Opportunities and considerations for the future of Ethereum block space

Author: Drew Van der Werff and Alex Ma, Frontier Research; Compilation: Vernacular Blockchain

TLDR:

1. History has shown that derivatives can strengthen spot markets and provide stakeholders in the supply chain with additional tools to manage their businesses. Likewise, Ethereum’s spot gas market could benefit from a derivatives market.

2. With the development of Ethereum Gas derivatives, there is an opportunity to launch a whole set of products to provide a better user and developer experience (ie, they can rely on paying a fixed Gas price) and increase the price of Ethereum block space found efficiency. Furthermore, derivatives significantly outnumber spot in most markets, offering significant opportunities in the broad design space.

3. Regulatory/legal, market and protocol specific factors need to be considered when designing these products. Furthermore, the maturity of market stakeholders must increase to support active trading of these products.

4. Difficult to know when this market will develop, but the consolidation of gas buyers (i.e. due to the development of L2/account abstraction), the increase of products available for hedging (i.e. pledged products), and the various stakeholders in the transaction supply chain increased complexity (i.e. through infrastructure improvements).

Throughout history, there have been examples of increased volatility in commodity markets as a result of exogenous events. While factors outside the market help reduce risk for commodity production and consumers (i.e. globalization leads to more efficient shipping/transportation and networks), derivatives serve as a tool for broader price discovery. **Additionally, derivatives can be used to better manage businesses that depend on the commodity. Similar opportunities exist in the Ethereum blockspace. With the development of block space derivatives, stakeholders can provide a better user experience, have more tools to manage their business, and improve the efficiency of block space price discovery. **Let's take a look at the current state of the Ethereum block space.

1. Introduction to Ethereum block space

The business model of Ethereum is the sale of block space. Various actors utilize Blockspace to interact with smart contracts, power applications, support additional infrastructure layers, or directly settle transactions. However, as with most resources, supplies are limited. To determine who or what consumes this supply, Gas is created. Stakeholders use Gas to specify how much they are willing to pay for included transactions.

Gas and its usage in Ethereum has evolved, with the most recent key change occurring in August 2021. With the implementation of the London hard fork and EIP-1559, Ethereum transformed its fee market to consist of a base fee, which is burned, and a tip sent to validators. With this change, the market now has a protocol-driven reference rate via base fees and ensures that for physical transactions, the costs associated with including transactions in blocks are minimal.

In September 2022, the merger is complete! This changes some of the dynamics associated with any potential derivatives market. After merging, validators responsible for proposing new blocks for finalization are known within two epochs, giving the market roughly 12 minutes to know who will stack the next block (which could have implications for a potential physical delivery market Interesting effects) ).

Finally, in the short term, the community may introduce a new market for fees related to data storage, called EIP-4844. This market will be Ethereum's first multi-dimensional fee market that separates data storage and execution. The implications of this and other roadmap items are discussed in detail below.

2. What we can learn from other commodity markets

To begin to understand the underlying design and market structure of the blockspace derivatives market and the potential impact on spot, we surveyed traditional markets, observing various attributes. Below are some key market indicators that we consider to be most comparable.

1. Non-tradable underlying assets: In its current form, Ethereum gas is not a direct transaction, but a transaction fee; we look for a market based on a non-tradable underlying index.

2. Cash and spot: Considering the dynamic change between the physical delivery of block space and the exchange of cash at maturity, we look for a cash-settled derivatives market, but the spot market is settled in kind

3. Stakeholders: A lot of activity and speculation needs to be driven by the actual use of the commodity/commodity

4. Market Microstructure: Where a transaction is placed in a block can have a major impact/overhaul on the price buyers are willing to pay. Therefore, we look for markets with similar microstructural dynamics driven by quality, geography, other metrics

Based on these factors, we found that the most relevant markets are oil and the VIX (fear index). More details are discussed below, but it is worth noting that both marketplaces are heavily used by various stakeholders to achieve a range of goals (i.e. better manage their business, hedge, watch the market, etc.).

1. Oil

Until the 1980s, the oil market was largely determined by a specific group of market participants (ie, parties with significant oil exports). By the end of the 1980s, a healthy spot market had developed, slowly replacing fixed-term fixed-term pricing contracts. However, even with this development, there remains a problem - this market requires physical delivery. Given the complexities of oil delivery, these markets are still dominated by a small number of players with long-term partnerships rather than being open to a wider range of players.

As these markets have matured, benchmarks such as US WTI have evolved to track the sum of spot prices for each grade in certain regions. This allows the market and other stakeholders to back and exchange oil in a standardized manner (i.e., you don't need to know the nuances of the region or market where oil is traded). With this development, not only are more participants able to generate views on prices, increasing the depth of market liquidity, but derivatives can now be developed on the index (index-based products are primarily cash-settled). The result is that more stakeholders are able to contribute to price discovery, arguably increasing efficiency and giving producers and consumers more powerful tools to manage their businesses. At present, the oil production of WTI and Brent futures contracts on ICE and NYMEX trading platforms can reach billions of barrels per day, while the global oil demand is about 100 million barrels per day; the futures trading volume exceeds daily oil consumption by more than 25 times.

2. Volatility Index/VIX

The VIX market originated from financial economics research in the late 1980s and early 1990s, and proposed a set of volatility indices that can be used as underlying assets for futures and options trading. A VIX acts like a market index, allowing traders to speculate on a group of stocks or, in the case of the VIX, the underlying volatility within the broader market. This allows participants to both speculate on future market uncertainty and hedge against market downturns when volatility is elevated but investors' stock portfolios may be affected.

However, unlike stock indices, the VIX itself is not tradable. Therefore, only cash-settled derivatives above the VIX can be traded. Still, since its inception in 2004, the VIX futures market has grown from an average daily volume of just about 460 contracts to about 210,000 contracts by 2022. This market structure is similar to the current natural gas market. Underlying gas cannot be traded. But the Ethereum block space market has observable and quantifiable properties. Therefore, creating a standardized Gas reference price is necessary for cash settlement of futures/options/swaps/ETPs. Fortunately, this has become easier after EIP-1559, which acts as a reliable oracle for the block space.

Three, product design considerations

While we can demonstrate from historical analogies the impact derivatives markets may have on the robustness of the Ethereum blockspace market, the Ethereum blockspace has unique features that will also determine how reference benchmarks and derivatives are designed. We believe the following should be top of mind for anyone working on developing a market/product. The following breakdowns are considerations around:

1. Market Structure: This section covers considerations surrounding blockspace/gas market participants, whether price makers can effectively hedge, potential consolidation of buyers, reference rate design, regulation, and some miscellaneous

2. Protocol/Roadmap: This section covers multi-dimensional spot gas markets, heterogeneity of the block space, miscellaneous and potential future roadmap items considerations

3. Cash and physical settlement: define cash and physical settlement, and discuss some design potential of physical settlement block space

1. Market Structure

Blockspace/Gas Market Participants: In any such market, there are price takers and price makers:

1. Price Takers** need to interact with the market to manage their business risk. **Going back to the oil market, these are both oil producers and subsequent supply chain players involved in oil refining or commercial use. Likewise, in the gas derivatives market, there are validators who provide block space, but then there are developers/users of applications that require block space. Stakeholders may wish to receive a fixed income for block space upfront, while applications/wallets may wish to receive a predictable fixed cost for their future block space needs. These participants ultimately hope to find a way to avoid being affected by dynamic price changes in the spot market, but two opposing sides form:

1. A: One party commits to selling block space in the future at the currently agreed price. On the other hand, it faces the risk of selling future block space at a cheap price;

2. B: One party commits to buying block space in the future at a currently agreed upon fixed price. This side runs the risk of paying too much for future block space.

2. Price Makers** are market participants who speculate and assume pricing risk. **In traditional markets, these roles are played by market-making departments of banks, asset managers, high-frequency trading entities, etc. These players are critical to creating more liquid and efficient markets. In the gas market, we see a role played by digital asset market makers, investment firms, and in the long run (like how oil producers have their own trading operations) validators themselves. However, there are currently not enough price makers in the market, mainly due to the lack of a liquid spot market to hedge against block space risk

1) Price setters cannot effectively hedge: The auction mechanism that drives the base fee for blockspace can be manipulated (especially in the short term) and tipping can be unlimited. As you can see below, the average gas price fluctuates wildly, and quite wildly if you look at it block by block.

Ethereum average gas price (Gwei)

These factors create significant risk for price setters, who expose themselves to variable costs with unlimited block space. Some of these issues could be addressed by time-based exponential smoothing of variable blockspace costs (reducing the impact of one-time spikes in costs on reference rates) or using alternative investment products that limit losses/gains. However, these approaches come with trade-offs, as they may not meet seller/buy side needs and generally reduce the effectiveness of long/short derivative hedging. Given this, we expect validators, block builders, and seekers to play a role in initially seeding the market short because of their natural supply or existing ability to access, optimize, and use blockspace supply ,

2) Consolidation of buyers: With the development of L2 and the transition that most users may access block space through aggregation / instead of L1, we expect L1 districts to complete L2 transactions through L2 operators / on L1 Buyers of block space will consolidate. Beyond L2, we expect further consolidation of blockspace buyers towards infrastructure and actors that abstract users from buying blockspace, such as block builders/AA/MPC+ middleware. Designing products for these stakeholders rather than individual consumers with widely different goals and needs should help narrow the scope of product design.

4) Regulations: Financial products such as derivatives (i.e. swaps, options, and futures) are often strictly regulated. For example, in the United States, the Commodity Futures Trading Commission is the primary regulatory agency responsible for overseeing most commodity derivatives offered, acquired, or sold by “U.S. persons.” If teams go down this route, they may need to (i) comply with certain CFTC rules and (ii) register with the CFTC. Additionally, if a product is offered outside of the United States, it may be subject to many other regulatory regimes. Finally, the global regulatory environment for digital asset derivatives is highly uncertain, with many jurisdictions lacking clear frameworks and guidance around legal treatment, regulation, regulation, and more. Classification of digital assets and market participants. Therefore, teams involved in building products (such as derivatives related to Ethereum blockspace) should seek appropriate legal advice before offering any such products, whether in the United States or elsewhere.

5) Other items: There are still some practical items that need to be optimized, including how these products are settled (i.e. daily/monthly), how collateral is managed, settlement and collateral mark-to-market management of derivatives, and trading The type of hedging (i.e. insurance-like product) that the parties are considering.

2. Agreement/Roadmap

**Multidimensional Spot Gas Market: **As part of EIP-4844, for the first time in Ethereum history, there will be a multidimensional fee market, creating two prices for Ethereum blockspace - one for data and one for for execution. **Both spot markets will use separate but similar pricing/auction mechanisms.

However, there may be pricing differences between the two markets given the differences in consumers and usage of data block space versus execution block space. As such, anyone designing blockspace derivatives may need to take this into account, and depending on how the spot market develops post-EIP-4844, may provide interesting insights for buyers/speculators and risk managers in both markets. hedging/trading opportunities.

**Heterogeneity of block spaces: **Not all block spaces are homogeneous. For example, there is block congestion where users only pay for block space including fees. Then there is competition, where users pay fees to express a desire to be included in a block in a certain order.

Derivatives may need to account for these dynamics or be designed for these specific players, given how consumers behave in each microstructure. While difficult to estimate, we looked at both quantitative and qualitative sources to understand where historical user preferences lie to help understand where near- and long-term opportunities may lie.

Gas price in wei for proposer payments by transaction position in the block (effective gas price - base gas price)

In the graph above we can see that some users are willing to pay an exponentially higher price for block top and post block space (i.e. contention), but the majority of users are only paying to get transactions through faster (i.e. congestion). A leading Ethereum Foundation researcher also recently speculated that large numbers of users prioritize congestion over contention. While there may be a competitive market related to MEV in the short term, it is expected that in the long term the largest market for blockspace derivatives will focus on congestion solutions.

Other Matters: In addition to the above, there are other considerations that may affect the derivatives market. These include forks and probabilistic finality, inclusion rates, and potential censorship by block builders and/or validators.

Further Developments: While it may take a few years, there will be further dynamics affecting the block space and any derivatives. Aside from EIP-4844, the most relevant and significant changes in our opinion are MEV-Burn, changes to any form of validator cap/staking economics, single-slot finality, and ePBS.

3. Cash settlement and physical delivery

Gas derivatives can be settled via "cash" or "physical delivery". More details follow, but cash-settled products often do not perfectly replicate the deliverable spot market because they typically provide synthetic exposure to commodities based on a reference rate. Therefore, the existence of a derivatives mechanism with physical delivery settlement function is crucial to ensure that the broader derivatives market on the block space accurately reflects the condition of the deliverable spot market.

PHYSICAL DELIVERY**: **Physical delivery of the Ethereum blockspace (and indeed any commodity market) is more complex than cash markets. Both parties to any such derivative must physically settle the commodity when the derivative expires. In the case of validators transacting with applications, this will require validators to provide block space to buyers. We discuss some potential methods of physically delivering blockspace below:

1) Block builders offer it as a service: As written before, due to economies of scale and technical requirements around full wet sharding, block building will likely continue to be dominated by a small number of players who Well-positioned to actively participate in these areas. market. Block builders are obviously natural buyers/sellers of block space (they are in the business of managing/optimizing block space after all) and may also run services for block space applications/consumers to provide block space physical delivery;

**2) Validator Coordination/Middleware: **In addition to block builders, validators are also major stakeholders in the market for the physical delivery of blockspace. This will be out of a desire to help manage the current volatile revenues of the entire validator business and allow for the development of a new market where validators can sell future block space for a premium. In order to do this, validators need to come together and leverage middleware as a coordination mechanism;

**3) Intra-protocol sale of future block space: ** While this would require a major protocol change, others have considered using an in-protocol mechanism to sell future block space, and some precedent for other networks has discussed the design , and research posts by Vitalik et al. on the inclusion list, Barnabe Monnot/Ma on the original PBS study, and Alex Stokes on soft pre-validation. We’ve also seen some teams experiment with smart contracts and OTC style transactions for proof of concept in the Ethereum testnet. Finally, other POS chains have considered integrating and adopting in-protocol block space futures to more efficiently allocate block space based on consumer demand.

4. Block Space Derivatives

We recognize that people have experimented with various derivatives of hashrate around the Bitcoin network. These markets have seen some growth, but are still limited for now.

Nevertheless, we also admit that it is still too early. After all, futures volumes in more mature ETH markets still pale in comparison to derivatives volumes in traditional commodity markets. Furthermore, in order for this market to thrive, with players such as block builders, validators, etc. becoming so competitive among these parties, applications will need to become more sophisticated that teams can leverage these products to Gain a competitive advantage over each other or can provide a unique product block space that relies heavily on managing the future.

Even with this timing in mind, we believe blockspace futures could have a unique impact on Ethereum, helping stakeholders better manage friction around gas and harden blockspace. We hope this post sparks a wave of discussion, developer tinkering, some hackathon projects, and innovation for the next decade.