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Intro
The concept of block space can be thought of as blockchain's pivotal product. As the guys from Bankless like to say, "Blockchains sell blocks." This relationship is produced through a symbiotic network of decentralized entities, encompassing both individuals and organizations, dedicated to upholding the protocols of public blockchains like Bitcoin and Ethereum. The essence of block space, regardless of its governance by a centralized entity or a decentralized network, is its global market presence, with transactions occurring every 12 seconds.
Blockchains represent an innovative computational architecture, delivering a novel category of compute characterized by unanimous global agreement. This technology addresses the critical challenge of value duplication in the digital realm. Consequently, block space is commercialized as a solution, commanding an annual consumer expenditure ranging from $5-$10 billion over the years 2021 to 2023.
The demand for block space, encapsulated by the gas price, serves as a barometer for its market value. This demand stems from a complex interplay of compute, storage, and bandwidth resources. The market for block space is diverse, with contributions from various layers and chains, including but not limited to Ethereum, Avalanche, Arbitrum, Optimism, Polygon, and Binance Smart Chain. A significant factor influencing consumer spending on transactions is the network effect associated with a particular block space. Consumers are inclined to engage more with block spaces that host a vibrant ecosystem of applications and users, a dynamic reminiscent of the viral growth seen in social media platforms.
The differentiation in block space pricing among various providers can largely be attributed to the network effect. This phenomenon is evident in the exponential growth in transaction fees, correlating with the expansion of a blockchain's network. Despite this growth, the market share of block space remains fluid, subject to continual shifts among competitors.
Ethereum Network Effects
Ethereum has the most extensive network effects of any cryptocurrency aside from Bitcoin. Ethereum’s established ecosystem of infrastructure, DeFi, NFTs, and ERC-20 tokens in combination with the ubiquity of the Solidity programming language and Ethereum Virtual Machine (EVM) have allowed Ethereum to maintain its lead as the leading smart contract blockchain despite scalability concerns.
Metcalf’s Law posits that the value of a network increases exponentially with the number of its users. This principle suggests that as more individuals or entities join a network, its utility and, consequently, its value grow at a rapid pace. The second principle highlights the negligible marginal cost of producing software. Once the initial investment in software development is recouped, adding additional users incurs minimal cost, enabling incumbents to dominate the market by leveraging scale to offer competitive pricing.
Applying these principles to Ethereum, we see a compelling case for its inevitable evolution into a monopolistic entity within the blockchain domain. Ethereum's value proposition is magnified by its robust network effects, fueled by an expanding ecosystem of developers, programming languages, the Ethereum Virtual Machine (EVM) standard, token standards, wallets, applications, and scaling solutions, alongside significant venture capital investment. Despite the open-source nature of blockchain projects, which allows for copying and forking, Ethereum demonstrates a "winner take most" dynamic, propelled by the challenges in simultaneously bootstrapping supply and demand in a decentralized environment. Factors such as brand recognition, user experience, and community engagement further solidify Ethereum's dominant position.
The ecosystem's growth is a self-reinforcing loop: an increase in users attracts more venture capital, which in turn expands the developer community, leading to more innovative applications and services, and thus drawing in even more users. This virtuous cycle is indicative of sticky network effects that are difficult to disrupt.
Despite the advent of newer blockchain platforms boasting superior performance metrics, Ethereum's extensive infrastructure—including its programming languages, standards for tokens and smart contracts, node networks, wallets, and venture capital backing—underscores its entrenched position. The concept that the best product does not always win, but rather the one that achieves critical mass and ecosystem support, is evident in Ethereum's enduring relevance and dominance in the blockchain sector.
Ethereum Value Capture
An intriguing aspect of this discussion is the cost associated with producing block space, particularly for Layer-1 (L1) blockchains like Ethereum and Avalanche. The economic model underpinning this process encompasses both transaction fees and block rewards, which, in turn, represent the cost of goods sold in the blockchain space.
Ethereum's economic structure, for example, incorporates a dual fee system under EIP-1559, alongside block rewards, to incentivize block production. The balance between incentivizing block production and maintaining an efficient, low-cost compute environment poses a fundamental challenge for L1 systems.
Integral to Ethereum’s long-term plan to act as sound digital money was the implementation of EIP-1559 in August 2021 during the London hard fork. The goal is to create a more efficient and simple gas payment process. EIP-1559 aims to improve user experience by reducing transaction wait times, mitigating fee-market uncertainty/volatility, and improving upon ETH’s imprecise gas usage for a typical transaction; this is in addition to introducing a burn mechanism.
EIP-1559 uses a mechanism similar to Bitcoin’s PoW difficulty adjustment to automatically find a dynamic equilibrium for gas prices. EIP-1559 changed Ethereum to have 2x the current block space but only target blocks to be 50% full (as opposed to nearly 100% currently). Therefore, over time, Ethereum’s blocks and block size will, on average, remain about the same, but the extra block space allows for flexibility with regard to transaction inclusion. If blocks get >50% full, gas costs increase. If blocks are <50% full, gas costs will decrease.
Prior to EIP-1559, Ethereum used a fee auction market structure to organize transactions similar to Bitcoin, where users place bids to compete for space on the next Ethereum block. Miners in PoW generally selected the transactions with the highest bids since they stood to collect all the fees. There was a gas ceiling of 12.5 million per block, meaning some transactions would get priced out until future blocks with a lower accepted fee.
The implementation of EIP-1559 and its fee-burning mechanism transformed ETH into a productive asset. Furthermore, the shift from Proof of Work (PoW) to Proof of Stake (PoS) reduced the rate of newly issued ETH. Since 'the Merge' in September 2022, Ethereum has ceased to distribute block rewards to miners, which has led to a ~90% drop in new ETH issuance, replacing ~14k ETH/day block rewards with ~1.7k ETH/day staking rewards. During periods of high network activity, this change has made the ETH supply deflationary.
EIP-1559 is a mechanism that enables Ethereum to reduce the net issuance of ETH as a function of the demand to transact on the network. This is the piece that makes ETH a consumable commodity. The combination of the base fee burn coupled with lower validator rewards in PoS plus ETH locked up in staking will result in a net negative issuance and shrinking circulating supply. Researchers estimate the supply equilibrium will eventually be between ~27-50 million ETH.
Image credit: Galaxy Digital
It also ensures that ETH is the only economic unit on Ethereum and removes the possibility of economic abstraction – the ability to pay fees in an asset besides Ether. Burning ETH also adds a deflationary mechanism to the ETH supply.
In addition to introducing variable block sizes to Ethereum, the London Upgrade and EIP-1559 increased the gas limit per block to 30 million; EIP-1559 also updated the structure of transaction fees. There will still be a base fee and a tip (or priority fee). The base fee is set by the protocol and adjusts every block based on network activity. The base fee no longer goes to miners but is instead burned. The tip is set by the market (can be zero in times of little congestion) and will go to the validators.
Source: TheBlock.crypto
How EIP-1559 Changes Value Capture on Ethereum
The economic model of Ethereum encompasses three critical components: total transaction fees, the portion of transaction fees that are burned, and staking rewards. Transaction fees are based on the supply and demand for the network's block space. Staking rewards are inflationary and add to the total ETH supply, while transaction fee burns introduce deflationary pressure on the native token. Over time, the reduction in supply can contribute to increasing the token's value.
The TL;DR of a hypothetical Ethereum transaction goes accordingly:
- Users initiate a block by paying 1 ETH as transaction fees, which includes Miner Extractable Value (MEV).
- Of the transaction fees, 0.8 ETH undergoes 'burning,' a process akin to a share buyback benefiting all ETH holders equally.
- The validator then garners 0.2 ETH from the transaction fees and an additional 1 ETH from block rewards. These rewards consist of newly minted ETH.
- If the validator received half of its stake from delegators, the validator is obligated to share 50% of its revenue with those ETH holders.
This process results in 0.8 ETH being burned, the validator receiving 0.6 ETH, and the ETH holders who participated in staking via delegation receiving 0.6 ETH.
Source: TokenTerminal
