Mastering Blockspace: A Scarce Crypto Commodity

March 12, 2022March 12, 2022

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With markets imploding across the world, every type of investor is reeling except one: commodity investors. Whether the cause is a stockpiling of physical assets, a supply chain crunch, or a commodity supercycle is largely irrelevant. Commodities are the one asset class that has managed to stay buoyant despite macroeconomic headwinds.

But what do physical goods have to do with crypto?

In this blog post let’s discuss a crypto-based commodity that’s simultaneously analogous yet uncorrelated with physical commodities. And while markets appear broadly bearish, this asset can show us that there continues to be major demand for crypto, although it’s now expressed in different ways than up-only price appreciation.

While this topic is discussed as it relates to the Ethereum network, but most of the concepts apply to all blockchains. There are some simplifications, but we’ve tried to make it as accurate and accessible as possible:

What Is Blockspace?

Blockspace is the commodity that powers the heartbeats of all cryptocurrency networks. In the blockspace market, miners are the producers, mining pools are the auctioneers, and users are the bidders. The influences of the blockspace market are so pervasive that they touch almost every facet of the cryptocurrency ecosystem.

Blockspace is the commodity that determines the cost to use a blockchain
Blockspace fluctuates in price
Blockspace has decaying value over time

To understand blockspace, we have to first understand blockchains themselves. Blockchains contain information separated into blocks. These sets of data are mined simultaneously and periodically. Blocks contain a limited amount of data (a group of transactions), and the way you can ensure your transaction makes it into the block is by participating in a gas auction.

Gas is the fuel of the Ethereum network. It is what is paid to miners as an incentive to validate transactions: this gas allows miners to pay their operating expenses, indirectly decentralizing and securing the network.

Those who pay a lot get their transaction included first, and those who pay just a little are required to wait longer for their transaction to be mined. This inherently creates variable demand for blockspace that is dependent on how many people are transacting at a time. As such, the price of blockspace, which is measured in gas, fluctuates meaningfully from day to day and week to week. All of this happens as the dollar price of Ethereum itself fluctuates.

Anyone who wants to participate in the Ethereum network has to pay gas, but the volatile and progressively increasing price of gas has effectively barred new users from participating in the network while complicating the business model of miners.

The Fundamental Value of Blockspace

Blockspace is more valuable in the present than in the future
Blockspace is valuable within a block and between blocks

If there’s strong demand for blockspace, what does that mean for its value? Why does it fluctuate so much? And what does this say about the value of Ethereum itself?

Unlike other commodities that can fluctuate both above and below the present (spot) price, blockspace is inherently more valuable in the present than in the future.

There are a few reasons why: first, the opportunity cost of waiting for a transaction (buying, selling, borrowing event) to go through. You want your transactions to happen instantaneously at the current price, and if you wait, the opportunity cost increases—having that money just sit around represents a cost incurred.

There’s also uncertainty to purchasing blockspace as a user. Remember, to send a transaction through on the network, you must bid for the blockspace. There are two potential problems with underbidding:

Your transaction can get frontrun (we’ll talk about this later)
Your transaction fails (and you pay the gas cost without a successful result)

Thus users tend to overbid to ensure their transaction gets through.

A phenomenon called miner-extractable value (MEV) can help us understand frontrunning. Imagine you’re trying to purchase a cryptocurrency for the market price of $1. Suppose in the previous block, someone sold that cryptocurrency for $1, making the price drop slightly. A ‘frontrunner,’ given they can sneak ahead of you in the list of transactions (typically by paying more gas than you), can buy at the discounted price and sell it back to you, earning a risk-free profit.

In summary: blockspace is in high-demand, has a limited supply, and has a decaying time value. It is a volatile asset.

Developing Financial Markets Around Blockspace

No sophisticated financial markets exist around blockspace
Sophisticated financial markets are necessary
Sophisticated markets can be created via derivatives

Imagine you’re a rice farmer. The price of rice fluctuates: sometimes it’s $1 a bushel, sometimes it’s $10 a bushel. Your rice will be ready to sell on August 20th and your break even point is $5 a bushel, but you’re worried that the price will be less than $5 on August 20th and you will incur a loss.

A forward contract is an agreement to sell that same rice in the future, say, for $6. Now you know you’ll make a profit of $1 per bushel. Thus, this derivative is created: the product being sold is not rice itself, but a contract for rice to be delivered at a future date.

Now imagine you’re the founder of a DeFi protocol. You face these same problems: you need to know how much Ethereum gas costs, your customers are facing strange and fluctuating prices, and you don’t know how that affects demand for your protocol. You can try to solve this by paying at lower-demand times of the day/week, but that’s a primitive solution that doesn’t truly eliminate the risks.

Effectively, both the rice farmer and the DeFi founder face the same problem. And while the rice farmer can eliminate the risk using a forward contract, sophisticated markets around blockspace don’t yet exist. Because of this gap in the market, we believe that the demand for a sophisticated blockspace market exists and gives us an investable thesis.

Investing In Blockspace

Go where there’s demand for blockspace
Blockspace derivatives protocols
L2s: The Blockspace Equalizers

The research questions around blockspace are fascinating in and of themselves, but there’s a bigger question around all of this: how do you make money by understanding blockspace?

Well, the first thing we can understand is our relative earliness to crypto. We have not even reached the futures contract stage of crypto markets, and sophisticated derivatives markets are still being developed. We see three opportunities for investors:

1. Buying Blockspace Demand: We can look at blockspace demand not only as a proxy for demand of a given crypto, but also as a revenue stream to evaluate.

Ethereum actually burns a percentage of gas fees, putting a deflationary pressure on supply. This produces value for the Ethereum token, and can be seen across other Layer 1s (although perhaps to a lesser extent).

2. Layer 2s: Given that gas transactions, in times of peak demand, are quite expensive, there is demand to make them cheaper. The most common fix comes in the form of scaling solutions called Layer 2s. Layer 2s sit on top of Ethereum, using the base network as a ‘settlement’ layer to basically finalize transactions. With more users avoiding the higher gas fees on Ethereum, Layer 2 activity will surge.

3. Commodities Protocols: The biggest punt, but perhaps the investment with the highest upside are protocols that commoditize gas.

One we find interesting is a protocol called Alkimaya, whose article on blockspace as a commodity piqued our interest in this topic. Alkimaya is building capital markets around this commodity, solving problems around risk for both blockspace producers (miners) and blockspace buyers (protocols, institutions). Miners can sell blockspace for a fixed price, or buyers can buy for a fixed price, allowing them to clearly forecast their balance sheets. Obviously, any business able to do this has a strong competitive advantage.

The swap contract used with Alkimaya will redistribute the two levels of risk that once was solely in the hands of miners:

Price risk of the underlying (rewards paid in X token are volatile)
Fee risk (network congestion)

Using commoditized blockspace markets, blockspace producers (miners) can hedge risks associated with running a node and pass it to another party.

In Summary…

If you believe that crypto is here to stay, by default you simultaneously believe that blockspace will be one of the most highest-demand commodities in the coming decades. The markets that create sophistication around this commodity will be likely rewarded for allowing builders and entrepreneurs in the space to redistribute risk.

Disclaimer: The information provided on this page does not constitute investment advice, financial advice, trading advice, or any other sort of advice and it should not be treated as such. This content is the opinion of a third party and this site does not recommend that any specific cryptocurrency should be bought, sold, or held, or that any crypto investment should be made. The Crypto market is high risk, with high-risk and unproven projects. Readers should do their own research and consult a professional financial advisor before making any investment decisions.