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From Zero to Crescendo — LayerZero Fundamental Analysis

Justmy2Satoshis
19 min readMay 13, 2023

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This fundamental analysis was published on April 13th, 2022, and is part of a weekly paid newsletter from the Crypto Consulting Institute that provides market insights, actionable trade signals, and monthly fundamental analyses. For more information on receiving FAs as they are released, visit: https://www.cryptoconsultinginstitute.com/newsletter

A new orchestra has started that has sourced the best performers from a wide range of classical instruments. Recitals kick-off, yet everyone is operating off a different music sheet.

The violins are asynchronous while completely out of alignment with the upbeat melody from the piano. The double bass completely drowns out the sound of the woodwinds.

It is a mess that is far from soothing to a would-be audience.

After several hours pass, the conductor finally arrives. They have their work cut out for them.

Getting each section to play off the same music sheet brings unity to the sounds. The piano takes on a more somber melody that aligns with the general tone of the orchestra piece, and the timing of the double bass is altered to give the saxophones room to shine.

If each musical section were left to its own devices, there would be discord about which song should be played, compounded by conflicts with the rest of the orchestra.

To play coherently, they must speak the same language and time their outputs to work toward a masterpiece. This does not mean a musician should put down their violin and start playing in the brass section. They need only to understand their role in achieving a coherent output.

The musical piece remains in shambles until a conductor arrives to get them playing from the same page and realign each section to produce something coherent.

This is not the first time you’ve read through an FA metaphor for interoperability. Projects we have covered, such as Polkadot and Cosmos, are akin to an orchestra section playing in separate halls, closed off from one another and unable to coordinate their output toward a unified masterpiece.

LayerZero, on the other hand, is more like the conductor that brings them all together. Ensuring that each section has only the relevant information it needs to create the necessary output toward a unified sound.

For this FA, we are doing things a little differently; first and foremost, there is NO LayerZero token to invest in at this stage. But due to the recent hype around $OP, $BLUR, and $ARB airdrops, we believed it pertinent to explore LayerZero. There are two key reasons to undergo this review.

The first is to take our understanding of Layer-0 technology to the next level to aid us in reevaluating our portfolio weightings of existing interoperable projects (including those previously covered). The second is to prepare ourselves to qualify if an airdrop occurs while gaining some practical experience with the tech.

To this end, we will review a handful of technical functions required for blockchains to achieve interoperability. Explore what block headers are, expand on our understanding of endpoints (touched on in last month’s FA; ANKR), and briefly touch on the importance of Oracle and Relayer independence in achieving interoperability.

From there, we will examine the differences between existing interoperable solutions and LayerZero, while briefly reviewing LayerZero’s flagship DeFi product; StarGate, Omnichain Fungible Tokens (OFT), and Omnichain Non-Fungible Tokens (ONFT). We will touch on some POSSIBLE action steps to qualify for a POTENTIAL airdrop and finish up with a discussion on the implications of LayerZero.

Naming the Pieces

“The proliferation of blockchains has given developers a variety of platforms on which to run their smart contracts based on application features and requirements for throughput, security, and cost. However, a consequence of this freedom is severe fragmentation; Each chain is isolated, forcing users to silo their liquidity and limiting options to move liquidity and state between walled ecosystems.” — Ryan Zarick

To understand Layer Zero technology, we have to take a few steps back to reflect on some critical components of how interoperability can be made possible on a blockchain. To keep it high level, we will touch individually on block headers, oracles, relayers, and endpoints in the context of interoperability.

As we have learned across a variety of different FAs, the Ethereum Virtual Machine (EVM) is the runtime environment for smart contracts on the Ethereum blockchain. Akin to a globally run computer that you can access locally.

When a transaction involving a smart contract execution occurs, it is included in a block. Each block in the Ethereum blockchain has a block header that contains essential information about the block. Without going into each of the over dozen required components, the block header plays a crucial role in ensuring the security and integrity of a blockchain by connecting blocks, summarizing their content, and providing proof of work for each block. EVM-compatible or equivalent blockchains closely emulate the required inputs to validate a transaction on-chain.

Oracles, as covered extensively in the Chainlink FA, play a vital role in achieving interoperability by providing access to off-chain data, enabling cross-chain communication, ensuring data reliability through decentralized oracle networks, offering standardized interfaces, and facilitating smart contract integration. By incorporating oracles into blockchains, developers can create powerful and interconnected dApps that can function seamlessly across multiple blockchain networks.

Relayers are off-chain entities that play a critical role in improving blockchain interoperability by facilitating communication and transactions between different networks or layers. They enable seamless interactions between various blockchain protocols and support the growth of decentralized applications by providing essential services like transaction broadcasting, data provision, liquidity provision, fee management, and order matching.

As previously reviewed in the ANKR FA, an endpoint, in the context of computer networks and software development, refers to a specific location or address where a service, application, or resource can be accessed and interacted with. Endpoints act as communication points between different systems or components, allowing them to exchange data or perform actions in one network leading to an outcome in another.

Blockchain endpoints may refer to the address or location of a node, blockchain explorer, or other services that provide access to blockchain data, transactions, or smart contracts. Users and developers can interact with these endpoints to send transactions, query blockchain data, or invoke smart contract functions.

Conductor’s Crescendo

LayerZero is a lightweight user application that composes of three key components to enable omnichain interoperability. Layer Zero endpoints, Chainlink DON Oracles, and Relayers.

Typically, an endpoint involves plugging a web-3 interface into a communicator, network, and validator. LayerZero endpoints, as a user-facing interface, leave these core components unchanged and add additional libraries for each chain that can route the relevant details required to provide a valid block header for a target chain.

For transactions submitted through a Layer Zero endpoint, an oracle reads the block header from the transaction submitted and stores it off-chain to transmit block headers to the target chain. The LayerZero endpoint facilitates send and receive functions through the user application (UA).

The relayer does not retrieve the block headers, but transaction proofs run through the endpoint for each transaction.

The oracle and relayer in the Layer Zero UA communicate with each other to validate a message that is executed as a transaction. The oracle and relayer are both independent of each other — their independence maintains a trustless exchange. Ultimately, these mechanics enable users to action resources on a source chain to initiate a transaction on a destination chain. This design enables native assets to be deposited on chain A, with native assets on chain B released to fulfill the cross-chain operation.

Many that bridge between blockchains at the user level rely on a Centralized Exchange (CEX). Depositing their assets from one network to withdraw them back to their network of choice. In this instance, they have to trust the centralized exchange to have enough liquidity to facilitate the bridging and that withdrawals will not be suspended, as they have for a plethora of reasons in the past.

The other option is to bridge assets through decentralized applications (DApps) that require the user to trust in the protocol smart contracts to deliver the assets on another chain, which is not an inherent guarantee as bridges, particularly in beta, tend to have issues with finality (assets actually appear on target chain, not stuck in bridging contracts). Further, the majority of Decentralized Finance (DeFi) hacks that have occurred have targeted lock and mint functions that are the bread and butter for most bridging DApps.

At the protocol level, interoperability is achieved in two key ways.

Middle Chains, such as Cosmos Hub and Polkadot Relay Chains, are cost-effective for bridging. However, they are granted all signing permissions required to facilitate cross-chain transactions. While both Cosmos and Polkadot have been rigorously stress tested to meet high network security standards, with centralized points of failure, it is often not a question of ‘if’ but ‘when’ an exploit occurs.

On-chain light nodes are an alternative to validating cross-chain transactions. Their relayers obtain block headers that are validated, and effectively duplicated, on both blockchains. While this messaging method to execute a cross-chain transaction is highly secure, the costs to run on-chain light nodes are often astronomical.

LayerZero differs with the use of Ultra Light Nodes (ULNs) that adopt the cost-effectiveness of Middle Chains with the security of on-chain light nodes. In this model, transactions are streamed by oracles, and transaction proofs are validated by relayers on demand instead of keeping all block headers sequentially and in full.

Through a highly generalized messaging service that is leveraged by the ongoing addition of LayerZero libraries and the immutability of the endpoint’s three key components, LayerZero is able to provide a lightweight omnichain application for protocols and blockchains to plug into that can be scaled with the addition of libraries that act as a proxy to translate each chain.

LayerZero provides Omnichain Fungible Tokens (OFT) and Omnichain Non-Fungible Tokens (ONFT) that can deploy a token contract on multiple blockchains and regulates supply through lock and mint functions for existing tokens.

We’ve touched on a limited number of technical aspects of LayerZero, but what does it look like in practice?

We can explore LayerZero in action through LayerZero’s proof of concept, StarGate Finance.

There are three key advantages to StarGate over existing bridging solutions.

Firstly, instant guaranteed finality ensures that when users and applications submit transactions, they execute on a destination chain.

Secondly, users are able to swap in native liquidity, which removes the need for wrapping or bridging tokens. A user could perform an action on Binance Chain that executes on Polygon.

Third is unified liquidity, where a user can deposit funds on one chain and take out a loan to realize funds from another, eliminating the need to wrap or bridge assets.

The latter point bears the need for greater emphasis as it unlocks a plethora of use cases, whereby a user may stake their $ETH in Ethereum while being able to utilize $MATIC on Polygon. Unified liquidity removes a number of processes that would otherwise present risk vectors at the contract level. Free flow of collateral is the outcome of unified liquidity, without token hopping, leading to greater capital efficiency by removing the need to pay fees for intermediate swaps and bridging.

‘Zero Tokens’ — Possible Airdrop Qualifiers

Outright, there is no Layer Zero token, any claims to the contrary are highly likely a scam. We briefly touched on StarGate Finance above, a product of LayerZero that does have a token; $STG. A deeper dive into StarGate Finance is beyond the scope of the current FA, but you can find out more information on tokenomics here.

We predicate the possibility of a LayerZero airdrop on a number of factors.

First, recent airdrops such as Arbitrum, Blur, Optimism, and speculation around a Metamask airdrop that has yet to eventuate, have seen an increase in the use of their native protocols and applications. As far as stress testing is concerned, having even a possibility of an airdrop will often lead to increased user activity.

Second, LayerZero has raised significant capital from equity raises from their initial $6.4M Series A fundraising to the more recent Series B raise of over $135M, over 20x the initial raise taking their company valuation to over $3B. As displayed above, LayerZero has raised capital from big names like Binance, Circle, Coinbase, Sequoia Capital, etc. Raising this much capital it can be assumed that there must be an internal roadmap toward generating internal revenue streams through the use of Layer Zero, or at the very least products that support investors operations. Regardless, LayerZero are likely in a position to make the market with available capital in the event of an airdrop.

Third, airdrops mitigate a key component of the Howey Act whereby users do not have to invest capital in receiving an asset they can later sell with the expectation of a profit. This tenet will likely be aggressively applied to cryptocurrencies going forward, and performing airdrops to those using their products reduces scrutiny on whether a token is a security.

“Airdrop guides” are purely speculative and are about creating hype for account engagement. When engaging with these types of tweets, extreme caution must be exercised to avoid being directed to malicious websites.

That aside, one from @ardizor on Twitter seems to propose some viable ways to participate in a snapshot (a network record up to a target date) that takes place to qualify users for a potential airdrop.

From most similar “airdrop guides”, they all seem to coalesce around the use of Stargate to facilitate bridging and transactions. Next time you want to bridge assets between blockchains, explore whether the methods outlined in this thread converge with your requirements. For those looking to farm airdrops, it would not hurt to start seeking some cost-effective routes of bridging to increase the chance of qualifying. If nothing eventuates, you still gain the experience and confidence to use more complex DeFi products.

Further, in regards to StarGate, there is mention of farming their $STG token from providing liquidity and staking it to receive governance powers. If this is your first time in DeFi, and you do not understand how to manage your risk, it is best to sit this out. Otherwise, stake some $STG, purchased off-market or received in farming rewards, to vote for proposals in the StarGate Governance forums to increase your chances of qualifying.

Participating in testnet is likely the safest way to qualify for any airdrop because it takes no upfront capital to participate. Recently, LayerZero finalized their Omnichain conversion of the $USDC token in testnet, making it native to all available EVM chains. Using testnet requires some discovery in terms of sourcing testnet tokens. However, in principle, it is exactly the same as how you would execute transactions through Metamask, only on a different network and at no personal expense. Keeping our eyes out for future testnet implementations would be a method with a high chance of qualifying for an airdrop.

The challenge with participating in many of these airdrops is there appears to be a requirement in many instances to use $USDC as the asset being locked and activated on an alternative chain. The goal from LayerZero’s perspective is volume. For those looking to participate, I would recommend beginning with small amounts of stablecoin before looking to move greater volumes. Keep in mind you are not exposing yourself to a minted or derivative asset by trialing the bridge with stablecoins. You are depositing an asset into a unified liquidity pool on one chain and withdrawing it on another chain in its native form.

List of possible bridges and protocols that may qualify you for airdrop:

Decrescendo and Refrain — Discussion

This review may appear overwhelming for those that have not managed to keep up with previous FA discussions on Layer-0 protocols, specifically Cosmos and Polkadot.

However, interoperability is a necessity for blockchains to become viable for mass adoption. This premise is universally accepted in the blockchain sphere, and it may be worth backtracking to previous FAs to reinforce some foundational semantics if required.

In this discussion, we need to reflect on the importance of getting up to speed with LayerZero and why even without a token, we may change the structure of our investments in terms of portfolio allocations to specific categories.

If interoperability is a part of your investment allocation, it may be time to reconsider how you are allocated. Protocols like LayerZero have the potential to front-run Polkadot and Cosmos’s dominant narrative.

However, it does not necessarily make these projects entirely redundant. Cosmos IBC can integrate LayerZero ULNs to significantly reduce the cost by removing the need to run Light Node Clients that would otherwise facilitate messaging to achieve interoperability. $ATOM and $DOT appear to be lacking inertia, and their communities appear to be rusted on (dev pun intended) without any strong signs of ongoing user onboarding. Given Cosmos and Polkadot have distinct communities that are acquainted with and use their DApps, it is unlikely they will simply vanish.

Rather, adjusting the investment category for both assets from L0 to L1 is worth considering. They each have their own unique ecosystem of DApps built on their network, so they should not be instantly dismissed.

That said, we need only review recent $ARB and $OP airdrop’s impact on their network activity relative to other L2s that did not offer airdrops for their network tokens. The optics of a possible airdrop attracts talent to a network. Protocols such as GMX emerged to set the standard for decentralized perpetuals and existing protocols that migrated benefitted from the volume of user activity seeking to qualify for a greater token allocation.

The likelihood of a $ZRO token airdrop has been speculated on parameters in the source code.

When it comes to LayerZero Labs, they raised $135M in their Series B equity raise and took their company valuation in excess of $3B. It is reasonable to assert that LayerZero has the capital to sustain an airdropped token.

The team that drives LayerZero Labs has strong leadership and a wealth of experience from the likes of Bryan, Caleb, and Ryan. Working around concepts of interoperability even before the genesis of Bitcoin certainly puts their resume on such a timeline that they’d have perspectives on achieving interoperability between traditional Web 2 and Web 3 blockchain-based solutions. Furthermore, they also have experience in AI solutions, which may throw an interesting spanner into the works for future applications.

The outstanding issue is how LayerZero would accrue internal revenue to make a token viable from the outset. LayerZero Labs launched StarGate Finance, which presents a viable revenue stream for the company through revenue allocated to the protocol treasury and the team allocation of $STG tokens. The potential airdrop, linked to the use of StarGate, seems viable as it creates a positive feedback loop for the company. Further, StarGate may be considered a litmus test for the demand for LayerZero; $STG is largely confined to the DEX narrative and represents a demand for LayerZero to a fair extent.

Beyond StarGate Finance, we need to consider whether it is practical for LayerZero Labs to release a $ZRO token. If LayerZero were to launch an independent network and/or ULNs and Relayers and become open source with token incentives to scale the interoperable capabilities, releasing a $ZRO token would be viable.

Interoperability can only be viable if we strip away the excess layers of computation and limit the number of contracts involved in the process. Interchain communication is not limited to cryptographic assets of value but also arbitrary user data. LayerZero opens the door to zero-value transactions and further proliferation of Web3 through ULNs, making on-chain light nodes and middle chains redundant to achieve interoperability.

If we were to name the differentiating factor of LayerZero over other solutions, it would be in the transition from a multi-chain model with fragmented ecosystems able to communicate and bridge assets to one another into an omnichain model where liquidity is unified, leading to greater capital efficiency and limited attack vectors with the removal of mint functions. Transitioning away from locking tokens on one chain to mint derivatives on another, toward depositing into a liquidity pool on one chain, and withdrawing from another, is the logical next step for interoperability.

OFT and ONFT omnichain standards are a significant development to consolidate risks with bridged tokens. Being able to deploy the same contract — not a clone, eliminates some but not all of the risk vectors with bridged tokens. On a technical level, there are fewer contracts involved that could be exploited. However, the lock and mint function still appears to be required for transitioning existing ERC20s, ERC721s, and ERC1155s into the omnichain standard.

Using a cross-chain product for the sake of it, in order to qualify for an airdrop does present risks.

From a capital preservation perspective, qualifying for a potential airdrop will come with a number of transaction fees, particularly heavy from Ethereum, that will add up over time. In addition to supplying liquidity pools (LP) to Layer-Zero enabled protocols like Sushiswap and StarGate, which may or may not be qualifiers, will accrue rewards but exposes LP providers to risks of impermanent loss. Similarly, when purchasing the $STG token to participate in governance, it is a requirement to lock up $STG for a period of time where it cannot be actioned in the event of having to manage the value of the position.

Best practice would involve substituting your existing approach to bridging assets cross-chain with LayerZero protocols instead of depositing into a CEX and withdrawing to the desired chain. Say you obtain USDC or ETH from Binance and want to hold or use those assets on the Arbitrum network; you may withdraw it to Ethereum Mainnet and then use StarGate to bridge your assets onto Arbitrum. While it may cost more than a direct withdrawal to the Arbitrum network from the CEX, you would register volume on your wallet address that may increase your possible qualifying tier for an airdrop. Bridging larger volumes would likely minimize the impact of protocol fees.

There is no roadmap other than ongoing efforts to integrate EVM and Non-EVM chains and protocols into Layer Zero. As mentioned above, it is highly likely, given leadership is deeply intimate with the need for interoperability and has experience with AI solutions, that they could produce a roadmap that would be an industry shaker. But, until the release of a token, it is not all that likely that we will receive clarity on the mid to long-term direction of LayerZero.

In terms of protocol risks, there was indeed a valid, yet suspiciously timed, risk assessment of LayerZero having an undisclosed backdoor capability into the protocol. Suspicious on two counts that James Prestwich is the founder of Norad, a competing bridge that experienced a 9-figure hack, and that it was shortly before a Uniswap governance vote (that passed) took place.

However, the assertion is valid nonetheless as a backdoor, meaning that a trusted party (LayerZero Labs) neglected to disclose they have the ability to compromise the system (pass arbitrary messages in the system without oracle and relayer validation).

Bryan Pellegrino responded that it was always present in the code and that all developers would need to do is adjust their configuration to eliminate the possibility of an attack vector. There is indeed a centralized point of failure for default configurations, but it is unlikely to be exploited as only the team can impact DApps integrated into a default configuration. It is up to developers to apply a custom configuration to eliminate the possibility of exploitation.

It is important to note that a UA that facilitates interoperability has us in unchartered territory. While the oracle can be maintained by Chainlink DON and additional oracle providers like Band, and the Relayers, whether the default Relayer operated by LayerZero labs or an independent Relayer configured by a developer does present possible risks. In isolation, it would only take the Oracle network or relayer to be exploited to validate malicious transactions. While it is highly unlikely to be the case, there is not a zero-chance probability, so we must always be cautious. Regardless, the benefits of trusting a relayer and oracle more than a CEX or lock/mint smart contracts are apparent based on the recent history of suspended withdrawals and the hundreds of millions lost through bridge exploits.

Regarding how we might approach $ZRO should it see the light of day, it is highly likely that networks that define themselves on the L0 narrative may see a sell-off. Cardano, Polkadot, and Cosmos may decline in the lead-up to an airdrop as those invested in the interoperability narrative seek to shift their portfolio weightings. In the meantime, brace yourself for existing blockchain solutions to continue to integrate Layer Zero. As sure as scaleability is a primary narrative to achieve mass adoption, it will amount to little without the network effects that will come from true interoperability.

References

Andreessen Horowitz, ‘Investing in LayerZero’, March 30th 2022, https://a16z.com/2022/03/30/investing-in-layerzero/

Boxmining, ‘LayerZero ($ZRO) Token Airdrop Guide’, https://boxmining.com/layerzero-token/

Coindesk, ‘Bridge Platform LayerZero Denies Allegations It Kept ‘Backdoor’ Secret’, January 31st 2023, https://www.coindesk.com/tech/2023/01/30/bridge-platform-layerzero-denies-allegations-it-kept-backdoor-secret/

Forbes, ‘Over $2 Billion Stolen This Year In Blockchain Bridge Hacks Expose DeFi’s Achilles Heel’, August 18th 2022 , https://www.forbes.com/sites/mariagraciasantillanalinares/2022/08/18/over-2-billion-stolen-this-year-in-blockchain-bridge-hacks-expose-defis-achilles-heel/?sh=4c06af73e50b

Medium, ‘LayerZero- An Omnichain Interoperability Protocol’, Ryan Zarick, September 16th 2021, https://medium.com/layerzero-official/layerzero-an-omnichain-interoperability-protocol-b43d2ae975b6

Medium, ‘Layerzero: The Possible Future of Blockchain Interoperability’, May 7th 2022, https://medium.com/blockchain-at-usc/layerzero-the-possible-future-of-blockchain-interoperability-7c7ed61ce433

Medium, ‘Layer Zero Potential Airdrop Guide’, November 29th 2022, https://airdropclaimers.medium.com/layer-zero-potential-airdrop-guide-dab72568ef6a

Medium, ‘LayerZero the future transport layer of IBC’, December 9th 2021, https://medium.com/layerzero-official/layerzero-the-future-transport-layer-of-ibc-32db19b1f253

LayerZero Docs, https://layerzero.gitbook.io/docs/

LayerZero Whitepaper, https://layerzero.network/pdf/LayerZero_Whitepaper_Release.pdf

StarGate Finance Gitbook, https://stargateprotocol.gitbook.io/stargate/v/user-docs/tokenomics/allocations-and-lockups

Substack, James Prestwich, ‘ZeroValidation: Admin Forgery in LayerZero’, January 31st 2023, https://prestwich.substack.com/p/zero-validation?utm_source=substack&utm_campaign=post_embed&utm_medium=web

TechCrunch, ‘Blockchain messaging protocol LayerZero raises $120M, hitting $3B valuation’, April 4th 2023, https://techcrunch.com/2023/04/04/blockchain-messaging-protocol-layerzero-raises-120m-hitting-3b-valuation/

TokenMetrics, Layer-Zero Code Review, https://research.tokenmetrics.com/layerzero-code-review/

Twitter, Potential Layer-Zero airdrop,

https://twitter.com/ardizor/status/1638148008888901632

Twitter, LayerZero Ecosystem Protocols,

https://twitter.com/wacy_time1/status/1645510571855593472

YouTube, 1Life Investments, ‘LayerZero Explained For Beginners — Why am I Bullish Like Everyone Else In Crypto?’, https://prestwich.substack.com/p/zero-validation?utm_source=substack&utm_campaign=post_embed&utm_medium=web

Layer Zero
Airdrop
Layer 0
Fundamental Analysis
Interoperability

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Justmy2Satoshis

Written by Justmy2Satoshis

130 Followers

Fundamental analyst at CCI. Full-time obsession with disruptive applications of blockchain technology.

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