Original article by Will Nuelle, General Partner, Galaxy Ventures
Original translation: Luffy, Foresight News
introduce
We previously pointed out in our article "Blockspace Business Models" that blockspace sales are one of four segments of the cryptocurrency market that can produce repeatable, robust product-market fit. Over time, we expect blockspace to become the second largest gross profit segment after exchanges, and even the largest gross profit segment as trading volume shifts from CEXs to DEXs. This is a B 2 B 2C business model, where blockchains attract application developers, and application developers attract consumers (both individuals and businesses) to use blockspace through their applications.
We also believe that blockspace is a network effects-based business, in stark contrast to its cousin business model, centralized cloud computing, which has economies of scale but no network effects. Network effects in blockchain exist in (i) application developers, (ii) application deployment, (iii) users, (iv) liquidity in the protocol, and (v) seed capital.
Galaxy predicts that block space consumption (measured in terms of the total amount of money spent consuming block space) will accelerate over time, and any future capacity increases to the blockchain will be filled by demand.
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 very different from non-MEV transactions. The demand for MEV comes from within the system (endogenous), while the demand for non-MEV transactions comes from outside the system (exogenous). MEV is an amplified version of the demand for block space, which is generated simply by other people using the system.
Non-MEV transactions: Users are willing to pay for this because they have an exogenous demand to use the application, such as paying stablecoin transaction fees or depositing into Compound.
MEV transactions: Users are able to obtain risk-free profits (or statistical risk-free profits) based on the state of the system. The exogenous demand for using the system creates the demand for consuming block space. In other words, it is endogenous demand.
In my research on blockspace as a business model, I have been thinking: how much demand does MEV contribute to it?
MEV is a driver of block space demand
As can be seen in the previous article "Blockspace Business Model", the total demand for blockspace on the top fee-charging blockchains reaches billions of dollars per year and is distributed in a power law:
Source: Will Nuelle, Galaxy Ventures
The daily transaction fees paid by users since September 2022 are as follows (time series shown on a logarithmic scale):
Source: Will Nuelle, Galaxy Ventures
MEV is a permanent feature 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, distributed between MEV searcher profits, validator tips, and ETH burned. These numbers do not include DeFi-CeFi arbitrage, which is statistical in nature, not atomic, and occurs both on-chain and off-chain.
Source: Will Nuelle, Galaxy Ventures
Searchers look for MEV opportunities and pay transaction fees to get a chance to include them in a block. Competition between searchers forces them to pay more transaction fees than normal blockchain transactions to ensure inclusion, so most of the transaction fees paid for MEV go into the pockets of validators, manifesting as the final returns received by validators being slightly higher than the returns from staking ETH. Some of this is destroyed according to EIP-1559, ultimately benefiting all ETH holders; some of it ends up being profits from the work of searchers. In 2023, the full MEV supply chain averaged $6.6 million per week, with a peak of over $20 million in May (excluding returns 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 launching front-running and reverse trades on casual DEX users. Atomic arbitrage is more beneficial because it has the effect of equalizing prices in the DEX pool, generating $126 million in total revenue in 2023. Liquidation (rewards for clearing bad debts in lending protocols such as Maker, Aave, and Compound) generated only $7 million in revenue in 2024. In addition to this, there are some other forms of MEV, but they are more customized than systematic.
Source: Will Nuelle, Galaxy Ventures
CeFi-DeFi arbitrage is a more difficult strategy to measure, and there is no public data to quantify the gains of CeFi-DeFi arbitrage (because CeFi is partially opaque). Data obtained by Galaxy tracking shows that CeFi-DeFi arbitrage earned 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 may be higher or lower depending on the specific Builder strategy. Note that the confidence interval for CEX-DEX arbitrage is large.
More interestingly, the gross margins of different strategies indicate which strategies are more profitable for Ethereum/validators and which are more profitable for searchers. The gross margins of Arbitrage and Sandwich strategies are 18.6% and 14.2% respectively, which means that these strategies are (i) highly competitive and (ii) they accrue more value to the base layer (ETH) in terms of fees. Meanwhile, Liquidation has a gross margin of 51.1%, but it has difficulty in achieving scale and is therefore less competitive (and less important for this discussion). CeFi-DeFi Arbitrage has some scale, but is less competitive due to deeper moats 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 has remained stable over time, neither rising nor falling. As can be seen in the above chart, MEV as a percentage of block space hovers around 10% each week. In weeks with large price and volume fluctuations such as the FTX crash, this percentage can rise to 30% of transaction fees. The week of the Silicon Valley Bank crisis, MEV also reached 25% of transaction fees. This is a mean-reverting time series with volatility very 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 transaction fee consumption in a given week is $100 million, we can simply predict that 90% of it is exogenous demand from using the application, and 10% is endogenous due to risk-free profits from state changes that week. If 30% is created by MEV and 70% is created by non-MEV, then it is reasonable to believe that there is a high probability that it will return to normal next week. We will keep an eye on this situation to see how it changes over time.
It is worth noting that this ~10% invariance 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, then the relevance of MEV will also decline in the absence of the discovery of new forms of stablecoins or game MEV.
Summary: MEV currently plays a small role, but will play an important role in the future
While MEV has the power to disrupt protocol incentives and is a perpetual consumer of blockspace, the actual financial contribution of MEV to Ethereum is relatively small at the moment, accounting for only 10% of transaction fees. In the weeks following a black swan market event like FTX or Silicon Valley Bank, this may rise to 25% or more, but this is the exception, not the norm, and historically this ratio has returned to a steady state. So what role does MEV play in the blockspace business model? In some ways, it is a demand multiplier effect, multiplying the exogenous demand to use an application by 1.1-1.3 times.
Nonetheless, the impact of MEV on future blockspace consumption could be significant. Blockchains like Solana and Monad have much cheaper per-transaction fees, and MEV could consume a larger percentage of blockspace on low-fee chains than on high-fee chains like Ethereum. To illustrate:
Source: Will Nuelle, Galaxy Ventures
The most profitable blockchains in the future will likely 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/sequencers/destruction of captured MEV.
The existence of phenomena such as MEV is just another reason why blockspace has become an unprecedented business model. Its unique characteristics make it a good business model and worthy of long-term investment. Finally, let's reiterate the advantages and disadvantages of blockspace:
Advantage:
Strong net revenue margins. Blockspace sales are the only business model with zero operating costs. Ethereum’s net revenue margins fluctuate widely, but since January 2023, its average net revenue margin has been 33.9%.
Easy to generate network effects. Generally speaking, SaaS products do not have network effects, while social media applications and marketplaces do. As more applications and capital join, the block space improves, which continuously drives up transaction fees with network effects. Network effects can generate additional revenue through MEV.
Blockspaces continue to grow in size over time. Some blockspaces will benefit from increased size, such as L2, which have the potential to grow further.
MEV’s exogenous demand multiplier effect. MEV is an ever-present feature of blockchain systems. While MEV may harm consensus, it contributes to the ecosystem on a large scale. For every $1 in transaction fees on Ethereum, approximately $0.10-0.30 in MEV fees is generated.
Weaknesses:
Gross margins are low, but improving. Producing one unit of blockspace (e.g. 1 M gas) is expensive and can require more than 66% of future profits from that blockspace. Blockspace is a low gross margin business.
Highly cyclical. The revenue from selling block space is highly cyclical. It depends on market conditions and is often closely tied to market volatility.
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