Future Opportunities and Thinking of Ethereum Block Space

Brief description:

• History has proven that derivatives can enhance spot markets and provide stakeholders in the supply chain with additional tools to manage their businesses. Likewise, Ethereum’s spot gas market may also benefit from the derivatives market.
• With the development of Ethereum gas derivatives, we have the opportunity to develop a whole set of products to provide a better user and developer experience (for example, users and developers can expect or rely on a fixed gas price without worrying about price fluctuations), and improve the efficiency of Ethereum block space price discovery. In addition, derivatives trade significantly more than spot in most markets, which presents significant opportunities in the vast design space.
• Regulatory/legal, market and protocol specific issues need to be considered when designing these products. Additionally, the level of sophistication of market participants must increase to support active trading of these products.
• While it is hard to know when this market will develop, favorable conditions are forming, such as concentration of gas buyers (i.e., due to the development of L2/account abstraction), increased products for hedging (e.g., staking products) As well as increased sophistication of the various stakeholders in the transactional supply chain (for example, through infrastructure improvements).

**Throughout history, there are many examples of commodity markets becoming more volatile due to external events. **Derivatives can serve as a broader price discovery tool, although factors outside of markets can help reduce risk for commodity-producing and consuming firms (e.g. globalization leading to more efficient shipping/transportation and networking). Additionally, derivatives can be used to better manage commodity-dependent businesses (eg, crude oil companies, precious metals, agricultural commodities). Similar opportunities exist in the Ethereum blockspace, with the development of blockspace derivatives, stakeholders can provide a better user experience, have more tools to manage their businesses, and increase blockspace price discovery s efficiency. Below we provide an overview of the current state of the Ethereum blockspace, historical analogs to traditional markets, and attempt to show key considerations for developing a blockspace derivatives market based on research by others.

Introduction to Ethereum block space

Ethereum's business model revolves around selling blockspace. Blockspace is utilized by various actors to interact with smart contracts that drive applications, support additional infrastructure layers, or directly complete transactions. However, like most resources, block space has a limited supply. In order to determine who or what can consume these supplies, Ethereum introduced Gas (a transaction fee paid for transactions on the blockchain network, called Gas). Gas is utilized by parties to specify how much they are willing to pay to include their 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 (London hard fork) and EIP-1559, Ethereum's fee market has changed to consist of a base fee that is burned and a tip for validators. After this change, the market now has a protocol-driven base fee that acts as a reference rate and ensures that for physical delivery, the minimum cost to include a transaction in a block.

In September 2022, "The Merge" happens! Although subtle, this also changes some of the dynamics associated with any potential derivative market. After the merge, the validators responsible for proposing the finalized new block are known two epochs in advance, giving the market about 12 minutes to know who will stack the next block (this could be very useful for a potential physical delivery market have interesting implications).

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

What we can learn from other commodity markets

To begin to understand the underlying design and market structure of the blockspace derivatives market, and its possible impact on the spot market, we surveyed traditional markets and observed various attributes, the following we identified among the most comparable markets Several key features:

• Non-tradable base: In its current form, Ethereum Gas is not directly tradable; we look for a market based on a non-tradable base index.
• Cash vs. Spot: Given the different dynamics between actual delivery of block space vs. exchange of cash at maturity, we look for derivatives markets to settle cash at maturity, and spot markets for actual delivery.
• Stakeholders: A lot of activity and speculation needs to be driven by actual use of the commodity/goods.
• Market Microstructure: A transaction's position in a block can have a significant impact/drastically change the price a buyer is willing to pay. So the markets we look for are those with similar microstructural dynamics driven by quality/geography/other metrics.

We found that based on these factors, the most relevant markets were oil and the VIX (Volatility Index, where a higher index means more volatility and more panic). More details are discussed below, but it is important to note that both marketplaces are already widely used by various stakeholders to achieve a range of objectives (i.e., better manage their businesses, hedge, observe etc).

oil

Until the 1980s, the oil market was largely dominated by a small group of market players, mainly oil-exporting countries. By the late 1980s, a healthy spot market had developed, gradually replacing fixed-term priced contracts. However, even with this development, there remains a problem - this market requires physical delivery. Given the complexities of delivering oil, these markets continue to be dominated by a small number of long-term partners rather than being open to a wider range of players.

As these markets continue to mature, benchmarks like U.S. West Texas Intermediate (WTI) are being developed to track the aggregate picture of spot prices from certain regions. This allows the market and other stakeholders to support and exchange oil in a standardized way (e.g. you don’t need to understand the nuances of regions or markets to trade oil). Through this development, not only are more actors able to gain insight into prices, increasing the depth of liquidity in the market, but derivatives can now be developed on this index (index-based products are mostly cash-settled). The result is that more stakeholders are able to participate in price discovery, which arguably improves efficiency and provides producers and consumers with more powerful tools to manage their businesses. At present, the trading volume of WTI and Brent futures contracts on the ICE and NYMEX exchanges can reach several billion barrels per day, while the global oil demand is about 100 million barrels per day; the futures trading volume exceeds the daily oil consumption by more than 25 times.

Volatility Index / VIX

The VIX market originated from financial economics research from the late 1980s to the early 1990s, and proposed a set of volatility indexes that can be used as the underlying assets for futures and options trading. A VIX works similarly to 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 to hedge against heightened volatility during market declines where investors' equity portfolios may suffer losses. However, unlike equity indices, the VIX itself cannot be traded. Therefore, only cash-settled derivatives based on the VIX can be traded. Nonetheless, since its launch in 2004, the average daily volume of the VIX futures market has grown from about 460 contracts to about 210k contracts by 2022. This market structure is similar to the current Gas market. Base Gas cannot be traded, but it is an observable and quantifiable property of the Ethereum block space market. Therefore, creating a standardized Gas reference price is necessary for cash settlement of futures/options/swaps/ETPs. Fortunately, this task has been made easier since EIP-1559, which acts as a reliable oracle about blockspace congestion.

Factors to consider when designing a product

While we can draw from historical analogies to show the impact derivatives markets may have on the stability of the Ethereum blockspace market, the Ethereum blockspace has unique characteristics that will also determine the reference benchmark and derivatives market. How the product is designed. We believe the following should be the first considerations for anyone working on developing a market/product. The following subsections are considered:

• Market Structure: This section covers considerations regarding blockspace/gas market participants, whether price makers can effectively hedge, consolidation of potential buyers, reference rate design, regulations, and a number of various other matters.
• Protocol/Roadmap: This section covers considerations regarding the complex spot gas market, blockspace differences, other matters, and potential roadmap considerations for future projects.
• Cash vs. Physical Settlement: Defines cash vs. physical settlement and discusses some design potential for physical settlement block spaces.

1 Market Structure

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

Price takers need to interact with the market to manage risk in their business. Returning to the oil market, these include both oil producers and subsequent supply chain players involved in the refining or commercial use of oil. Likewise, in the Gas derivatives market, there are validators who provide block space, but then there are applications/users who require block space. These actors may wish to secure a fixed income for block space upfront, while applications/wallets may wish to secure a predictable fixed cost for their future block space needs.

These participants ultimately wish to avoid exposure to the dynamic price movements of the spot market, but two opposing sides form:

**Short position: One party promises to sell the block space in the future at the current agreed price, which faces the risk of pre-selling the future block space at a price that is too low. **

**Long side: One party commits to buying block space in the future at the currently agreed fixed price, and this side faces the risk of overpaying for future block space. **

Price makers are market participants who speculate and assume pricing risk. In traditional markets, these roles are played by market makers of banks, asset management companies, high-frequency trading entities, etc. These players are critical to creating more liquid and efficient markets. In the Gas market, we see this role being played by market makers in the digital asset market, investment companies, and in the long run, validators themselves. However, there are currently not enough price makers in the market, mainly because there is no spot market with sufficient liquidity to hedge against block space risk.

Price setters cannot effectively hedge: The auction mechanism that drives the base fee for block space can be manipulated (especially in the short term), and tips can be unlimited. As shown in the figure below, the average Gas price fluctuates greatly, and if the block is observed by block, the volatility will be even greater.

These factors create significant risk for price makers as they expose themselves to an uncapped variable cost of block space. Some issues can be smoothed out by using time-based indicators (to reduce the impact of a single cost rise on the reference rate) or by using other investment products that limit losses/gains. However, these approaches have trade-offs, they may fail to meet seller/buy side needs, and generally reduce the long/short hedging effect of derivatives. Given this, we expect validators, block builders, and searchers to initially act as short sellers of the startup market, as they have the ability to naturally supply or acquire physical block space, existing optimization and utilization of block space supply capabilities, and experience in managing block space risk.

Concentration of buyers: With the development of L2 and the possibility of most users accessing block space through rollup / instead of L1, we expect buyers of L1 block space to complete L2 through L2 operators / on L1 People who trade come to centralize. Beyond L2, we expect further centralization of block space buyers towards infrastructure and actors that enable users not to buy block space directly, such as block builders/AA (account abstraction)/MPC (decentralized private key saved technology) + middleware. Designing products for these stakeholders, rather than individual consumers with broad goals and needs, should help narrow down product design.

Reference interest rate design: If the product is cash-settled, the reference interest rate is an important design feature for market prosperity, and the design in this aspect needs to balance long positions

2. Agreement/Roadmap

Complicated Spot Gas Market: As part of EIP-4844, for the first time in the history of Ethereum, a multi-dimensional fee market has emerged, which creates two prices for Ethereum block space - one for data and one for execution. The two spot markets will use separate but similar pricing/auction mechanisms. However, due to the difference in data block space consumers and execution block space usage, there may be price differences between these two markets. So anyone designing blockspace derivatives might want to take this into consideration and potentially provide buyers/speculators and risk managers with interesting trade-offs between these two markets depending on how the spot market develops post-EIP-4844 hedging/trading opportunities. Also, although it is still early days, researchers in the community have mentioned that there will be further fragmentation of the fee market, which will create additional microstructures.

Differentiation of blockspaces: Not all blockspaces are homogeneous. For example, there is block congestion, which covers block space that users can include for only a fee. Then there is competition, where users pay a fee to express their 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 the behavior of consumers in each microstructure. While this is difficult to estimate, we looked at both quantitative and qualitative sources to understand where historical user preferences lie, helping to understand where near-term and long-term opportunities may be.

In the graph above, we can see that some users are willing to pay exponentially more for block space at block headers and trailers (i.e., competition), but most users only pay for inclusion (i.e., congestion) . A leading researcher at the Ethereum Foundation also recently speculated that a large number of users prioritize congestion over competition. While there may currently be a market associated with competition, based on the above and other MEV-related dynamics, we expect the largest blockspace derivatives market to focus on congestion in the long term.

** Various other considerations: ** In addition to the above, there are other considerations that may affect the derivatives market. These include forks and probabilistic finality, confirmation rates (a low confirmation rate creates congestion and the network is slow to process blocks), and possibly censorship by block builders and/or validators.

Further developments: While likely still a few years away, there will be further dynamics affecting the blockspace and any derivatives. Aside from EIP-4844, we think the most relevant and talked about changes are MEV-Burn, any kind of validator cap/staking economics change, single transaction finality, and ePBS (Block unicorn notes: ephemeral blocks Proof of space and time. This is a new consensus algorithm. Its design goal is to improve the propagation efficiency and security of blocks in consideration of network delay and broadcast costs. In ePBS mode, verifiers no longer only Blocks are generated according to the rights and interests held by them, but they need to be carried out according to their status and performance in the network. This can make the generation and dissemination of blocks more fair and effectively prevent network attacks).

Block unicorn note: MEV-Burn is only part of the Ethereum roadmap that directly addresses MEV issues. The solution returns MEV to ETH holders by burning the value currently being extracted by MEV participants. This amounts to an indirect redistribution of value to ETH holders, making the asset more scarce and reducing selling pressure on block validators.

3. Cash settlement and physical delivery

Gas derivatives can be settled in "cash" or through "physical delivery". More details below, but in general, cash-settled products cannot fully replicate the deliverable spot market because they provide synthetic exposure to the commodity, usually based on a reference rate. Therefore, the existence of a derivatives mechanism for physical delivery settlement is crucial. It ensures that the broader blockspace derivatives market accurately reflects conditions in the deliverable spot market.

Physical delivery: Physical delivery in the Ethereum blockspace (and indeed any commodity market) is more complex than cash markets. Both parties to any such derivative must physically settle the goods when the derivative expires. In the case of a validator transacting with an application, this means that the validator needs to provide block space to the buyer. We discuss several possible ways of physical delivery of block space below:

Block builders provide this service: As noted in previous posts, due to economies of scale and technical requirements for fully deep sharding, block building is likely to continue to be dominated by a small number of players who good. Block builders are obviously the natural buyers/sellers of block space (after all, they are in the business of managing/optimizing block space), and can also provide block space physical delivery services for block space applications/consumers.

Validator Coordination/Middleware: In addition to block builders, validators are also the main stakeholders in the physical delivery market of the block space. This will be driven by a desire by validators to help manage the volatility of revenue in the current validation business and allow for the development of new markets where validators can sell future block space for a premium.

About block space derivatives We recognize that there have been various attempts at hash rate derivatives around the Bitcoin network. There has been some growth in these markets, but they are still limited. While these markets may be ahead of their time, the market structure friction surrounding hash rate derivatives does not exist in the underlying Ethereum blockspace market - most importantly a wider range of natural market participants, Possibility of increased flow, bilateral market growth. However, we also acknowledge that it is still too early. After all, futures volumes in the more established ethereum markets are still overwhelmed by derivatives volumes in traditional commodity markets. Also, for this market to thrive, roles like block builders, validators, and applications need to become more proficient, and the competition between these players has become so fierce that teams use these products to gain access to Each other's competitive advantage, or can provide a unique product that relies heavily on managing future block space.

While this timing is on our minds, we believe blockspace futures could have a unique impact on Ethereum, helping stakeholders better address gas and blockspace related issues. We hope this post sparks a wave of relevant discussions, developer musings, some hackathon projects, and innovations to emerge over the next decade.