Galaxy Partner: MEV will play an important role in the block space market

Introduction

We previously pointed out in the article "Blockspace Business Model" that the sale of blockspace is one of the four segments of the cryptocurrency market that can produce repeatable and robust products Market fit. Over time, we expect the block space to become the second-largest gross profit-generating market segment behind exchanges, and possibly even the No. 1 gross-profit market as trading volume shifts from CEX to DEX. It is a B2B2C business model where blockchain attracts application developers who in turn attract consumers (both individuals and businesses) to use the blockchain space through their applications.

We also believe that block space is a business based on network effects, in sharp contrast to its similar business model, centralized cloud computing, which has economies of scale but no network effects. Network effects in blockchain exist among (i) application developers, (ii) application deployments, (i) users, (iv) liquidity in the protocol, and (v) original capital.

Galaxy predicts that block space consumption (in terms of the total amount spent consuming block space) will accelerate over time, and any future capacity increases in blockchains will be driven by demand. fill.

MEV Economics

In this article, we will evaluate the proportion of block space consumed by MEV transactions and discuss why it is important for evaluating block space as a business model.

MEV transactions are distinct from non-MEV transactions. MEV demand comes from within the system (endogenous), while non-MEV transaction demand comes from outside the system (exogenous). MEV is an amplified version of the block space requirement that is created simply by other people using the system.

• Non-MEV Transactions: Users are willing to pay for this because they have an exogenous need to use the application, such as paying stablecoin transaction fees or depositing into Compound.
• MEV Trading: Users are able to earn risk-free profits (or statistically risk-free profits) based on the system state. Exogenous demands for using the system create demands for consuming block space. In other words, it is endogenous demand.

In the research on block space as a business model, I have been thinking: How much demand does MEV contribute to it?

MEV is the driving factor for block space demand

It can be seen from the previous article "Block Space Business Model" that the total demand for block space on top fee-based blockchains reaches Billions of dollars per year, with a power-law distribution:

Source: Will Nuelle, Galaxy Ventures

The daily transaction fees paid by users since September 2022 are as follows (time series shown in logarithmic scale):

Source: Will Nuelle, Galaxy Ventures

MEV is a permanent function of the blockchain and a permanent consumer of block space. The chart below shows MEV on Ethereum (the only chain with good public MEV data) as of the end of February 2024, split between MEV searcher profits, validator tips, and ETH burned. These numbers do not include DeFi-CeFi arbitrage, which is statistical in nature rather than atomic and occurs on-chain and off-chain.

Source: Will Nuelle, Galaxy Ventures

Searchers find MEV opportunities and pay transaction fees to Get the chance to be included in the block. Competition among searchers forces them to pay more transaction fees than normal blockchain transactions to ensure inclusion, so of the transaction fees paid for MEV, most of it goes into the pockets of the validators, manifesting as the validators gain The final income is slightly higher than the income from staking ETH. Some of it is burned under EIP -1559, ultimately benefiting all ETH holders; some of it ends up being profit from the work of the searchers. In 2023, the complete MEV supply chain averaged $6.6 million in weekly revenue, peaking at more than $20 million in May (excluding gains from CeFi-DeFi arbitrage).

MEV Strategy

Different MEV strategies have different benefits and profit margins. Data shows that sandwiching, a parasitic form of MEV, generated $212 million in revenue on Ethereum last year by initiating front-running and reverse trades on casual DEX users. Atomic arbitrage is more beneficial as it has the effect of equalizing prices in DEX pools, generating $126 million in total revenue in 2023. Liquidations (rewards for clearing bad debt from lending protocols like Maker, Aave, and Compound) generated just $7 million in revenue in 2024. Beyond that, there are some other forms of MEV, but they are more customizable than systematic.

Source: Will Nuelle, Galaxy Ventures

CeFi - DeFi Arbitrage is a harder one to count strategy, and there is no public data to quantify the benefits of CeFi-DeFi arbitrage (because the CeFi part is opaque). Data obtained by Galaxy Tracking shows that CeFi-DeFi arbitrage made about $98.5 million in 2023, but only accounted for about 60% of the market share. This is based on simulations of CeFi quote data, but could be higher or lower depending on the specific Builder strategy. Note that the confidence intervals for CEX - DEX arbitrage are large.

More interestingly, the gross margins of the different strategies indicate which strategy brings more profits to Ethereum/validators and which strategy brings more profits to searchers. The arbitrage and sandwich strategies have gross margins of 18.6% and 14.2% respectively, which means these strategies (i) are highly competitive and (ii) they accumulate more value for the base layer (Ethereum) in terms of fees. At the same time, although the liquidation strategy has a gross profit margin of 51.1%, it is difficult to achieve scale and therefore less competitive (and less important in the discussion of this article). CeF i -DeF i arbitrage has some scale but is less competitive due to a deeper moat in terms of order flow, builder concentration and general statistical arbitrage complexity.

Source: Will Nuelle , Galaxy Ventures

Source: Will Nuelle, Galaxy Ventures

There is a stable relationship between MEV and block space demand

MEV as a percentage of transaction fees paid, Remains stable over time, neither rising nor falling. As you can see from the chart above, MEV as a percentage of block space hovers around 10% each week. During weeks with high price and volume volatility, such as the FTX crash, this percentage can rise to 30% of the trading fee. The week of the Silicon Valley banking crisis, MEV also hit 25% of transaction fees. This is a mean reverting time series that fluctuates much like financial markets. In fact, MEV activity may be closely related to volatility itself.

Source: Will Nuelle , Galaxy Ventures

Source: Will Nuelle, Galaxy Ventures

In other words, if the transaction fee burn in a given week is $100 million, we can simply predict that 90% of it comes from using the app 10% of the exogenous demand for the program is endogenously generated due to the risk-free profit brought about by the status change during the week. If 30% is created by MEV and 70% is created by non-MEV, then it is reasonable to believe that there will be a high probability of a return to normal next week. We will be watching this closely to see how it changes over time.

It is worth noting that this immutability of around 10% only applies to financial applications on the blockchain (DEX and lending protocols). These applications generate MEV, not stablecoin applications or games. If the dominance of financial applications declines over the long term, MEV’s relevance will also decline in the absence of new forms of stablecoins or gaming MEV being discovered.

Summary: MEV currently plays a smaller role, but will play an important role in the future

Although MEV has the ability to destroy protocol incentives and is a permanent consumer of block space, MEV currently has little impact on Ethereum The actual financial contribution is relatively small, accounting for only 10% of transaction fees. In the weeks following a black swan market event such as FTX or Silicon Valley Bank, this ratio may rise to 25% or higher, but this is the exception rather than the rule, and historically the ratio has returned to steady state. So what role does MEV play in the blockchain space business model? In some ways, it is a demand multiplier effect, multiplying the exogenous demand for usage of the application by a factor of 1.1-1.3.

Nevertheless, the impact of MEV on future block space consumption may be significant. Blockchains like Solana and Monad have much cheaper per-transaction fees, and MEV will likely consume a greater proportion of block space on low-fee chains than high-fee chains like Ethereum. Give a simple example to illustrate:

Source: Will Nuelle, Galaxy Ventures

Future Most The blockchains that make money are likely to be those that simultaneously: (a) reduce transaction fees and stimulate demand for network activity, and (b) primarily leverage network activity in the form of validators/orderers/burn capture MEV .

The existence of phenomena like MEV is just another reason why the block space is becoming a business model that has never been seen before. Its unique characteristics make it a good business model and worthy of long-term investment. Finally, we reiterate the advantages and disadvantages of the block space:

Advantages:

• Strong net income margin. Block space sales are the only business model with zero operating costs. Ethereum’s net revenue margin fluctuates, but since January 2023, its average net revenue margin has been 33.9%.
• It is easy to produce network effects. Generally speaking, SaaS products do not have network effects, while social media applications and marketplaces do. As more applications and capital come on board, block space improves, continuing to drive higher transaction fees with network effects. Network effects can generate additional revenue through MEV.
• As time goes by, the size of the block space continues to expand. Some block spaces will benefit from increased scale, such as L2, which have the potential for further growth.
• Exogenous demand multiplier effect of MEV. MEV is an ever-present feature of blockchain systems. MEV, while potentially damaging consensus, contributes fees to the ecosystem at scale. For every $1 in transaction fees on Ethereum, there are approximately $0.10-$0.30 in MEV fees.

Weaknesses:

• Gross profit margin is low, but improving. Producing a unit of block space (e.g. 1M gas ) is expensive and may require more than 66% of the future profits of that block space. Block space is a lower gross margin business.
• Strongly cyclical. Revenue from selling block space is highly cyclical. It depends on market conditions and is often closely related to market volatility.

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