Keynote: The Evolution of Blockspace Economics
Speaker: Leo Zhang, Co-Founder and CEO, Alkimiya
Stage: Wemade Stage

TOKEN2049 Singapore 2022

#token2049 #alkimiya #blockspace #economics #blockchain #crypto

is Leo, I'm the founder of Halcamia, we're building a DeFi protocol for decentralized capital markets for block space users, as well as producers.

And today my presentation is on the evolution of block space economics.

So you probably heard ridiculous claims made by VCs that the block space is the most interesting commodity to sell in the 21st century and it's the foundation of metaverse, blah, blah, blah.

But block space is a very basic component of the blockchain.

We use it for every single on-chain interactions, and it's been there since the genesis block.

a sudden has it become such an interesting topic?

And what do we really mean when we talk about block space economically in this context?

So first and foremost, the block space itself is a marketplace, right?

So there are producers, the supplier of the block space, are the miners and staking validators.

They expend some kind of resources, whether it's electricity or hardware depreciation or the opportunity cost of the coins that is staked.

Or for in some of the other staking validators case, for example, Solana, the hardware requirement is extremely high, almost as expensive as running a Bitcoin mining operation.

So on the supply side, they expend the resources and periodically produce BlockSpace at a predetermined schedule.

And on the demand side, when we talk about the user of BlockSpace, we mean anyone who's initiating an on-chain action, and this could be your MBV searcher, a service company, or exchange, or anyone that's moving from 1 address to the other.

So the BlockSpace has pretty interesting market dynamics too.

So on the supply side, for the miners and the staking validators, this is a classic commodity production business.

This is the same as producing precious metal, making coffee beans.

And so for them, they have a relatively more predictable cost.

You know exactly how much you're paying for electricity, for labor costs, how much you acquire those stakes for initially, and how much you have to pay to maintain the hardware.

However, the income, the revenue component of the staking validators as well as miners, that is utterly unpredictable.

Because you're exposed to the price of the coin over the period

of time, you're exposed to difficulty or validation share in proof-of-stakes case.

your income comes from the fee, which is highly, highly volatile.

So these 3 factors, the coin price, difficulty slash validation share, as well as fees, they're cross correlated, but with a lag.

What that means is that you can't just simply create right linear projection to collapse the other factors into 1.

want to hedge by just shorting the perp, you can't really establish a full hedge.

the block space producers is predictable, but the revenue is not.

So for Bitcoin mining specifically, the game has become incredibly, incredibly competitive.

And it takes at least 30, 40 million US dollars to start even a small mining operations.

So in the last bull market, we saw a lot of mining companies, they put on a lot of leverage, they overpurchase the machines, and and there are a lot of spec deals, a lot of companies going public.

But in when the market changed, Very quickly, they are unable to service their loans.

A lot of consolidation happening in this business.

So for staking, the problem is less severe because their business model is less required with leverage and require less upfront payments.

But still, block space production is an extremely cyclic business.

And now on the demand side, the hallmark of, the key characteristics of the demand side of block space is the time value.

So what do we mean by the time value of block space.

So a block space that you can secure right now is far more valuable than the block space that you may secure in the future.

And this is because any transactions on the blockchain, you don't actually know the final execution price until this transaction gets included in a block and appended to the blockchain.

And, you know, any time between your transaction can get front run, can get sandwiched, or simply fail as the gas becomes more expensive.

So and the reason that anyone needs to pay this fee to get your transactions included, to be able to interact with the block space in

a permissionless manner, is that all transactions, no matter how complex or simple, they consume certain resources.

And these resources can be computation, can be storage, can be bandwidth.

these different ways of consuming resources are metered by 1 single metric, which is gas.

So there are some explorations on, okay, perhaps making different transactions use the different resources differently.

But this, so this is under the scope of multi-dimensional EIP-1559.

It's probably not going to happen until, I don't know, 5 years later.

But anyways, so gas is often bounded due to the block size, this way that otherwise it's impossible to run a full node.

So and because the block size limitation, block space itself is a scarce resource.

So for Bitcoin, it's produced once every 10 minutes, for Ethereum, 12 seconds.

And so this makes it the closest thing to a crypto native digital real estate.

Anyone who wants to produce any kind of economic activity on the blockchain need to purchase a share of this land.

So due to this imbalance of the supply and demand, which and again, the supply is finite, it's capped at 12 seconds per block.

And whereas the demand, it can scale to infinity.

So we can observe some very interesting patterns on the block space, particularly how people use the block space.

So we can study some of the behavior patterns on block space through the lens of financial microstructure.

So first of all, the most common usage of block space are the exchanges, which shouldn't be any surprise to anybody.

However, because the first price auction nature, even after switch from first price auction to EIP-1559, we still see gas as the single metric, the single expression of the collective urgency of using the block space itself.

So for example, the chart on the right, so this is during the time of the Yuga Labs Other Deeds Mint.

can see, the gas price increased significantly, almost instantaneously.

But it took about 1, 000 blocks after the mint happened for the gas price to revert to normal.

So Euglide was extremely sorry, and they had to subsidize users' gas expenditure.

And they paid $150 or $180 million from their treasury.

So this is extremely unpleasant for both the project team as well as for users or for people who don't even care about NFT and just using the blockchain regularly.

So another huge factor that contributed to these interesting dynamics on Blockspace, especially recently, is the rise of MEV activities.

So MEV activities inherently, it's just not solvable.

It's no matter what kind of fences that we're putting there or remove it from 1 place to another, it's just inherently bounded.

It's inherently, sorry, unbounded due to the complexity of the layer ones.

So we fully expect that the most of the block space activities to be filled by MEV activities and going forward.

And this phenomenon is only going to get worse or better.

It depends on what exactly you do from here.

So if we look at MEV activities on a day-to-day basis, it's extremely volatile.

And you can't really predict any kind of trends of MEV income, mostly because there are a lot of factors, exogenous to the layer 1 itself, that are influencing the profitability of MEV income.

So as a result, the daily gas is extremely volatile as well.

This is particularly awful after the merge, and it has nothing to do with the consensus mechanism itself, it's just because the lower issuance rate, so a higher percentage of the income for a

block space producers is going to come from MEV activities.

So as a result, this any influence, any fluctuation of MEV activities is going to make the gas costs much more volatile.

So zooming in, there are actually a lot of very interesting things that we can observe on the gas behaviors.

So first of all, gas, even though it's a single meter that measures all the resources, but we can actually break it into different priority percent of priorities.

And they don't often behave in a predictable way.

So for example, this is during the time of the notorious UST meltdown.

This is during the time of notorious UST meltdown.

So at that time, there were a lot of MEV opportunities, tons of liquidation and everyone is just trying to get out of their positions.

percentile priority gas costs, this was by far the most volatile piece of the gas costs.

Usually when the blockchain is more quiet, we can see that this volatility starts to trend more into the middle and sometimes even to the lower priority percentile.

So anyways, there's just tons of very interesting observations that we can make given the nature of how this market works.

So it's pretty obvious that the hedging needs of the block space producers and the block space users are the opposite.

So for the block space producers, and again, these are miners and stake validators, they have fixed costs, but their revenue is a floating risk.

And for Blockspace users, they want to pay a predictable or somewhat predictable gas in order to exchange for, to recycle the actual gas that is spent on chain.

So for companies like Circle or NFT Mint, they're able to cancel all the floating part.

So here at Alchemia, when we think about, okay, what is the financial primitive to tie the hedging needs of the block space producers and block space users together, we think that the basic construction should be float-to-fix swaps.

So for the block space producers, they can sell their floating risks to exchange for something that's fixed.

So for miners, they can lock in their production income at the beginning of every month.

they can get rid of the more volatile components.

And for a user of Blockspace, a frequent user of Blockspace, they can pay

a fixed amount to better manage their gas expenditures if they know roughly how many transactions they're going to process over the course of X number of blocks.

So there's several interesting use cases.

So right now, in a bear market, gas is sort of an afterthought, But this is definitely not going to last very long, especially as more interactions start to pick up.

So for frequent user of the block space, they can use this type of instruments to manage their gas expenditure.

and more commercial activities are going to move on chain.

And it doesn't matter if it's on apps, physical roll ups or on the layer 1 directly.

Gas, sorry, cost management is going to be a

more and more important part for these companies, treasury management.

And for this also, they are a very interesting sort

of like natural yield that represents the economic activities accrued on the block space itself.

So, looking across the DeFi universe in the past cycle, most of the activities were filled by cheap leverage lending activities.

And this is pretty much gone now, especially as the 10-year just hit 4%.

Liquidity provisioning, it's getting less and less interesting as the token price is dropping.

So in order to look at look to build something that's sort of akin to, okay, what is the sort of natural yield, the sort of the closest thing to a risk free rate that is native to the blockchain, okay, then lending your stake to the protocol and get that block space subsidy as well as the fees is the closest thing that we can source that natural yield.

So if we think that more digital activities are going to be built on blockchain, more commercial activities are going to happen on block space, then the continuous and steady production of the block space, as well as the steady, predictable usage of the block space, is incredibly important.

So, and for similar to, you know, classic commodity production business, most of these activities are supported by large volumes of fusions and options.

And similarly, we can expect that this commodity, the digital native commodity, which is Blockspace, its production as well as consumption will be supported by its own version of fusions options and derivative of the market that's native to its functionality.

So there are actually a lot of very interesting insights from how people use gas and sort of different behavior of gas.

And this is too short of a presentation, but we publish

And if you're interested in this kind of stuff for some reason, definitely check out the website.


Speaker 0: Hi everyone, my name

Speaker 1: is Leo, I'm the founder of Halcamia, we're building a DeFi protocol for decentralized capital markets for block space users, as well as producers. And today my presentation is on the evolution of block space economics. So you probably heard ridiculous claims made by VCs that the block space is the most interesting commodity to sell in the 21st century and it's the foundation of metaverse, blah, blah, blah. But block space is a very basic component of the blockchain. We use it for every single on-chain interactions, and it's been there since the genesis block.

So why all of

Speaker 0: a sudden has it become such an interesting topic?

Speaker 1: And what do we really mean when we talk about block space economically in this context? So first and foremost, the block space itself is a marketplace, right? So there are producers, the supplier of the block space, are the miners and staking validators. They expend some kind of resources, whether it's electricity or hardware depreciation or the opportunity cost of the coins that is staked. Or for in some of the other staking validators case, for example, Solana, the hardware requirement is extremely high, almost as expensive as running a Bitcoin mining operation.

So on the supply side, they expend the resources and periodically produce BlockSpace at a predetermined schedule. And on the demand side, when we talk about the user of BlockSpace, we mean anyone who's initiating an on-chain action, and this could be your MBV searcher, a service company, or exchange, or anyone that's moving from 1 address to the other. So the BlockSpace has pretty interesting market dynamics too. So on the supply side, for the miners and the staking validators, this is a classic commodity production business. This is the same as producing precious metal, making coffee beans.

And so for them, they have a relatively more predictable cost. And this is more fixed on

Speaker 0: a month-to-month basis. You know exactly how much you're paying for electricity, for labor costs, how much you acquire those stakes for initially, and how much you have to pay to maintain the hardware. However, the income, the revenue component of the staking validators as well as miners, that is utterly unpredictable. Because you're exposed to the price of the coin over the period

Speaker 1: of time, you're exposed to difficulty or validation share in proof-of-stakes case. And in Ethereum, a large component of

Speaker 0: your income comes from the fee, which is highly, highly volatile. So these 3 factors, the coin price, difficulty slash validation share, as well as fees, they're cross correlated, but with a lag. What that means is that you can't just simply create right linear projection to collapse the other factors into 1. So if you

Speaker 1: want to hedge by just shorting the perp, you can't really establish a full hedge. So as a result, the expenses for

Speaker 0: the block space producers is predictable, but the revenue is not. So for Bitcoin mining specifically, the game has become incredibly, incredibly competitive. And it takes at least 30, 40 million US dollars to start even a small mining operations. So in the last bull market, we saw a lot of mining companies, they put on a lot of leverage, they overpurchase the machines, and and there are a lot of spec deals, a lot of companies going public. But in when the market changed, Very quickly, they are unable to service their loans.

A lot of consolidation happening in this business. So for staking, the problem is less severe because their business model is less required with leverage and require less upfront payments. But still, block space production is an extremely cyclic business. And now on the demand side, the hallmark of, the key characteristics of the demand side of block space is the time value. So what do we mean by the time value of block space.

So a block space that you can secure right now is far more valuable than the block space that you may secure in the future. And this is because any transactions on the blockchain, you don't actually know the final execution price until this transaction gets included in a block and appended to the blockchain. And, you know, any time between your transaction can get front run, can get sandwiched, or simply fail as the gas becomes more expensive. So and the reason that anyone needs to pay this fee to get your transactions included, to be able to interact with the block space in

Speaker 1: a permissionless manner, is that all transactions, no matter how complex or simple, they consume certain resources. And these resources can be computation, can be storage, can be bandwidth. And so right now, all of

Speaker 0: these different ways of consuming resources are metered by 1 single metric, which is gas. So there are some explorations on, okay, perhaps making different transactions use the different resources differently. But this, so this is under the scope of multi-dimensional EIP-1559. It's probably not going to happen until, I don't know, 5 years later. Anyways, that's a different topic.

But anyways, so gas is often bounded due to the block size, this way that otherwise it's impossible to run a full node. So and because the block size limitation, block space itself is a scarce resource. So for Bitcoin, it's produced once every 10 minutes, for Ethereum, 12 seconds. And so this makes it the closest thing to a crypto native digital real estate. Anyone who wants to produce any kind of economic activity on the blockchain need to purchase a share of this land.

So due to this imbalance of the supply and demand, which and again, the supply is finite, it's capped at 12 seconds per block. And whereas the demand, it can scale to infinity. So we can observe some very interesting patterns on the block space, particularly how people use the block space. So we can study some of the behavior patterns on block space through the lens of financial microstructure. So first of all, the most common usage of block space are the exchanges, which shouldn't be any surprise to anybody.

However, because the first price auction nature, even after switch from first price auction to EIP-1559, we still see gas as the single metric, the single expression of the collective urgency of using the block space itself. So for example, the chart on the right, so this is during the time of the Yuga Labs Other Deeds Mint. So as you

Speaker 1: can see, the gas price increased significantly, almost instantaneously.

Speaker 0: But it took about 1, 000 blocks after the mint happened for the gas price to revert to normal. And so that was about 3 to 4 hours. So Euglide was extremely sorry, and they had to subsidize users' gas expenditure. And they paid $150 or $180 million from their treasury. So this is extremely unpleasant for both the project team as well as for users or for people who don't even care about NFT and just using the blockchain regularly.

So another huge factor that contributed to these interesting dynamics on Blockspace, especially recently, is the rise of MEV activities.

Speaker 1: So MEV activities inherently, it's just not solvable. It's no matter what kind of fences that we're putting there or remove it from 1 place to another, it's just inherently bounded. It's inherently, sorry, unbounded due to the complexity of the layer ones. So we fully expect that the most of the block space activities to be filled by MEV activities and going forward. And this phenomenon is only going to get worse or better.

It depends on what exactly you do from here. So if we look at MEV activities on a day-to-day basis, it's extremely volatile. And you can't really predict any kind of trends of MEV income, mostly because there are a lot of factors, exogenous to the layer 1 itself, that are influencing the profitability of MEV income. So as a result, the daily gas is extremely volatile as well. This is particularly awful after the merge, and it has nothing to do with the consensus mechanism itself, it's just because the lower issuance rate, so a higher percentage of the income for a

Speaker 0: block space producers is going to come from MEV activities. So as a result, this any influence, any fluctuation of MEV activities is going to make the gas costs much more volatile.

Speaker 1: So zooming in, there are actually a lot of very interesting things that we can observe on the gas behaviors. So first of all, gas, even though it's a single meter that measures all the resources, but we can actually break it into different priority percent of priorities. And they don't often behave in a predictable way. So for example, this is during the time of the notorious UST meltdown. This is during the time of notorious UST meltdown.

So at that time, there were a lot of MEV opportunities, tons of liquidation and everyone is just trying to get out of their positions. So the

Speaker 0: 95

Speaker 1: percentile priority gas costs, this was by far the most volatile piece of the gas costs. But this is not always the case. Usually when the blockchain is more quiet, we can see that this volatility starts to trend more into the middle and sometimes even to the lower priority percentile. So anyways, there's just tons of very interesting observations that we can make given the nature of how this market works. So it's pretty obvious that the hedging needs of the block space producers and the block space users are the opposite.

So for the block space producers, and again, these are miners and stake validators, they have fixed costs, but their revenue is a floating risk.

Speaker 0: And for Blockspace users, they want to pay a predictable or somewhat predictable gas in order to exchange for, to recycle the actual gas that is spent on chain. So for companies like Circle or NFT Mint, they're able to cancel all the floating part. So here at Alchemia, when we think about, okay, what is the financial primitive to tie the hedging needs of the block space producers and block space users together, we think that the basic construction should be float-to-fix swaps. So for the block space producers, they can sell their floating risks to exchange for something that's fixed. So for miners, they can lock in their production income at the beginning of every month.

For staking validators,

Speaker 1: they can get rid of the more volatile components. And for a user of Blockspace, a frequent user of Blockspace, they can pay

Speaker 0: a fixed amount to better manage their gas expenditures if they know roughly how many transactions they're going to process over the course of X number of blocks. So there's several interesting use cases. So right now, in a bear market, gas is sort of an afterthought, But this is definitely not going to last very long, especially as more interactions start to pick up. So for frequent user of the block space, they can use this type of instruments to manage their gas expenditure. So if we think that more

Speaker 1: and more commercial activities are going to move on chain. And it doesn't matter if it's on apps, physical roll ups or on the layer 1 directly. Gas, sorry, cost management is going to be a

Speaker 0: more and more important part for these companies, treasury management. And for this also, they are a very interesting sort

Speaker 1: of like natural yield that represents the economic activities accrued on the block space itself. So, looking across the DeFi universe in the past cycle, most of the activities were filled by cheap leverage lending activities. And this is pretty much gone now, especially as the 10-year just hit 4%. Token inflation, this part is gone now. Liquidity provisioning, it's getting less and less interesting as the token price is dropping.

So in order to look at look to build something that's sort of akin to, okay, what is the sort of natural yield, the sort of the closest thing to a risk free rate that is native to the blockchain, okay, then lending your stake to the protocol and get that block space subsidy as well as the fees is the closest thing that we can source that natural yield. So if we think that more digital activities are going to be built on blockchain, more commercial activities are going to happen on block space, then the continuous and steady production of the block space, as well as the steady, predictable usage of the block space, is incredibly important. So, and for similar to, you know, classic commodity production business, most of these activities are supported by large volumes of fusions and options. And similarly, we can expect that this commodity, the digital native commodity, which is Blockspace, its production as well as consumption will be supported by its own version of fusions options and derivative of the market that's native to its functionality. So yeah, and this is it.

So there are actually a lot of very interesting insights from how people use gas and sort of different behavior of gas. And this is too short of a presentation, but we publish

Speaker 0: a lot of research.

Speaker 1: And if you're interested in this kind of stuff for some reason, definitely check out the website. Thank you.

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The Evolution of Blockspace Economics - TOKEN2049 Singapore 2022