New models will emerge in the Ethereum mining cycle and new income channels will emerge

Information source: Paradigm, slightly modified, author: Georgios Konstantopoulos & Leo Zhang

Blockspace Market Overview

Blockspace is the commodity that powers all cryptocurrency networks. In the blockspace market, miners are producers, mining pools are auctioneers, and users are bidders. The impact of the blockspace market is so pervasive that it touches nearly every aspect of the cryptocurrency ecosystem.

After a user initiates a transaction, it is propagated peer-to-peer in the memory pool of each node. Each transaction has a fee attached to it. The fee indicates a willingness to purchase block space, which allows the transaction to be processed and packaged into a block.

At every moment, countless proposed blocks exist in this "Schrödinger state" between unconfirmed and confirmed, competing to find the first hash output that meets the difficulty target. Each block has a probability of becoming the next block. By contributing billions of calculations per second, miners can break down the probability wave and materialize the ledger history.

Since the size of a block is capped, the number of transactions that can pass through it in a given time is limited, giving block space an implicit time value. Transactions that remain unconfirmed for a long time may be affected by market fluctuations or preempted by arbitrage bots. The fees users pay to purchase block space reflect their willingness to bid. The block space market brings miners and users together.

On the surface, the blockspace market appears complex and chaotic due to the lack of central coordination. It relies on detailed rules, procedures, and the convergence of supply and demand to self-regulate. How do we know if the current market design is optimized for success?

Nobel Prize winner Alvin E. Roth is considered a pioneer in the field of market design. In his seminal book, Who Gets What—and Why, he argued that in order to function properly, markets need to do at least three things:

1. Market depth: There are enough potential buyers and sellers to interact. In the case of a block space market, suppliers are incentivized by block rewards to provide computing power. On the other hand, as more people use the network to trade, the demand for block space increases.

2. Security: Market participants must feel safe to disclose or process confidential information they may hold. Due to the transparent nature of on-chain transactions, users who submit sealed bids may not always get the results they want. In addition, transactions require a high degree of settlement assurance. That is, there should be enough computing power to make reorganization expensive.

3. No congestion: Transactions should be completed or canceled in a timely manner. When a market cannot effectively cope with the congestion caused by transaction volume, participants may not be able to get their transactions included in the block without much delay. As can be seen from the recent popularity of Ethereum Dapps, gas fees have also skyrocketed due to congestion.

Throughout the history of Bitcoin and Ethereum, the design of the optimal blockspace market structure has often sparked many heated debates. In the following sections, we will explain the structure of the Ethereum blockspace market from the perspective of supply (miners) and demand (users). We examine whether the current blockspace market design provides depth, relieves congestion, or is safe and easy to participate. We will then discuss popular suggestions for optimizing market structure and possible future development directions of the blockspace market.

Supply Side: The Structure of Ethereum Mining

The ultimate goal of the entire mining industry is to provide a decentralized transparent clearing house for block space.

This task is by no means trivial. In a distributed system that operates around the world 24/7 without an authoritative coordinator, miners need to provide strong settlement guarantees for anonymously auctioned block space, generating extremely complex calculations to secure the network by investing large amounts of money in hardware and energy.

Despite widespread concerns about the centralization of hashrate, the mining industry is not a single organism. Fluctuations in the block space market affect each component to varying degrees; and each miner is heavily influenced by factors such as location, machine type, temperature, maintenance, and mining strategy.

Bitcoin and Ethereum mining have very different market structures. Bitcoin and some PoW coins have almost completely migrated to the ASIC era. On the other hand, despite Ethereum having the second largest market capitalization, there are almost no ASICs in existence. Although rumors of new ASIC manufacturers appear every once in a while, it is estimated that currently about 80-90% of Ethereum's hash rate is dominated by GPUs.

Structurally, how does a market of blockspace vendors that is primarily comprised of GPUs differ from a market that is primarily comprised of ASICs?

GPU mining all originates from NVIDIA and AMD. They either sell independent graphics cards directly or wholesale GPU chips and memory to downstream graphics card manufacturers. These manufacturers in turn remove the functions that are not related to mining, so this is called a "mining card".

There are far more OEMs than in the ASIC market. As a result, Ethereum's hashrate composition is much more diverse than a typical ASIC network. This also makes it difficult for distributors to monopolize the channel. Miners have more options, and they don't have to wait for ASIC manufacturers such as Bitmain and Whatsminer to resolve supply chain constraints. This means that initial supply is generally not bottlenecked like ASICs using advanced back-end processes. In addition, GPU miners are not bound to any specific network. Miners engaged in speculative mining almost exclusively use GPU miners. In addition, retail GPU graphics cards are also valuable in other computing fields such as gaming, data centers, and artificial intelligence work. In general, GPU miners are more flexible in their hardware choices.

Structure determines nature. The hardware makeup determines the industry’s capital expenditures and energy consumption. These two factors are critical when calculating mining expenses, and they have a cascading effect on other parts of the mining ecosystem: from manufacturing, distribution, hosting facilities, gas fee fluctuations, preferences for EIPs, to the defining characteristics of its mining cycle.

In The Alchemy of Hashpower, we introduced four typical phases of the mining cycle based on the relative rates of change of Bitcoin price and network hashrate:

Due to the inherent lack of liquidity of hardware, network computing power often lags behind price changes. “Hardware reaction time” is determined by various exogenous factors such as manufacturers’ supply chain constraints, foundry wafer backlogs, equipment capacity, and even shipping logistics.

During last year's bull market, miners and investors rushed to order new machines. On the other hand, manufacturers have just begun to recover from supply chain disruptions during the epidemic, and the global shortage of integrated circuits has forced all semiconductor companies such as mining, automobiles, and consumer electronics to line up for wafer allocation.

Additionally, NVIDIA announced that they will artificially weaken the performance of Ethash on the latest graphics cards to prevent miners from buying up all GPU inventory. This means that unless the price or fees continue to rise significantly, the "inventory cleanup" and "shuffle" phase when the backlog of machines finally come online may be very painful.

In Ethereum, mining income comes mainly from three aspects:

1. Coinbase reward (2ETH per block + uncle reward)

2. Transaction Fees

3. Miners can extract value

Ethereum's transaction fees as a percentage of total block rewards is much higher than Bitcoin's. This means that Ethereum miners not only pay attention to the price of the coin, but also to the trend of gas fees. Even if the price of the coin remains unchanged, the increase in transaction fees will be enough to motivate Ethereum miners to increase computing power.

In addition, as discussed in the previous sections, due to the flexibility of GPU selection and distribution, it is easier to scale up or down the computing power compared to ASIC networks. Therefore, Ethereum mining cycles tend to be shorter:

Shorter cycles mean that competition accelerates when mining revenue is high, while flexibility in hardware selection means that hashrate is more easily unwound when mining revenue is low. Unit profit margins (block rewards per Megahash/s) can fluctuate wildly, so predicting revenue will be challenging:

The significant increase in coin prices and fees attracted more miners to participate. However, unlike most commodity markets, more producers do not mean an increase in block space supply. The supply of block space is determined by block size and average block time. This means that the increase in computing power has not reduced network transaction fees, but has increased the network's security budget. As more miners join the competition, the cost of reorganizing historical blocks becomes higher and higher, thereby improving the network's settlement security.

Demand side: Time value of block space

Since the block size is limited, users need to compete for the system's resources. For any user who initiates an on-chain transaction, the fee model determines the core user experience.

Ethereum’s utility has risen rapidly as the most popular platform for storing and executing smart contracts. DeFi’s “money legos” allow products and services to connect to each other in a permissionless manner and greatly promote the innovation of new financial solutions.

Today, Ethereum users participate in the blockspace market through repeated first-price auctions. This is a simple auction model where users submit bids for their transactions to be included in the next block, and this bid is paid to miners in the form of transaction fees. Users can choose their bids through the "gas fee" of their transaction (measured in gwei/gas). Observation of mining pool transaction selection methods shows that more than 75% of mining pools follow the default strategy of no priority. That is, transactions are simply listed in descending order of fee without prioritizing any specific address.

Its market structure is simple: users want to minimize the fees they pay to miners to enjoy a smooth experience, while miners want to maximize their revenue since they are for-profit entities.

It is an indisputable fact that the fees paid by users will always obey the law of supply and demand: block space per second is a scarce asset, so users who want their transactions included immediately will always pay more in fees than users who are willing to wait for the next block, as is evident from the shape of the queue of waiting transactions below.

Blockspace is the closest thing to “digital real estate” in the cryptocurrency space. Blockspace has intrinsic value as “real estate” where economic activity occurs.

For miners, the time value of future block space is low due to uncertainty in price, network difficulty, fees, etc. For users, the time value of future block space is similarly low due to uncertainty in the profitability and utility of their transactions.

Congestion and costs

The time value of block space will directly translate into the amount of fees paid by users. Under this fee model, estimating the "correct" gas fee is a difficult problem, which can be clearly seen from the fluctuations in the gas fee of a single block:

Recall Roth's three requirements for successful market design: depth, security, and overcoming congestion. It is obvious that in the case of congestion, gas fees tend to soar too high for ordinary users. Where exactly is the bottleneck?

This unpredictability stems from the fact that users cannot coordinate the correct fee to be included in the next 1, 5, or 10 blocks. Today, most users adopt a "bid once" approach: they broadcast their transaction once and then wait for it to be included. By allowing users to express their fee preferences over a series of blocks, such as using a fee upgrade algorithm, continuous improvement can be achieved.

The first versions of a new technology are always crude. Multiple versions have emerged over the years to address congestion. Market design for blockspace involves balancing the interests of multiple factions in the ecosystem. At this juncture, we have discussed three possible avenues:

1. Short term: Increase block size, temporary patches may pose security risks.

2. Medium term: Changing the auction mechanism requires community consensus.

3. Long term: scalability solutions like rollups and ETH 2.0.

Some may be tempted to increase the block size so that it can accommodate more transactions (i.e. increase supply, assuming demand remains constant). This change would only be a temporary painkiller to ease the pain of high fees, as new demand would quickly fill up blocks, driving up fees again. Additionally, block size increases make blockchain node software more resource intensive, and should be avoided in order to keep the system decentralized.

Another approach is to restructure the bidding process. Today, all blockchains implement a "generalized first-price auction" for their fee mechanism. The EIP-1559 proposal changes this mechanism to sell at a fixed price when the system is not congested, allowing users to easily choose the "best" bid based on their preferences (contrary to the status quo).

EIP-1559 is also one of Ethereum's most controversial topics to date. With more than 60% of mining pools expressing opposition to the proposal, EIP-1559 has evolved into a "trade war" between block space users and producers. While its exact impact on miners' fee income is difficult to quantify, there is a general consensus in the mining industry that gas fees need to rise sharply to make up the difference. A'jian, an outspoken critic of the proposal in the Chinese Ethereum community, believes that EIP-1559 "will lose the loyalty of miners." Kevin Pan, founder of Poolin, believes that it will not actually have much impact on mining revenue, but it is "extremely insulting."

However, not all miners think so. The founders of F2Pool, who are active users of DeFi products themselves, support the proposal. Even Jihan Wu, the notorious instigator of the Bitcoin block size civil war, expressed support for changing the fee mechanism. Ultimately, human coordination in an unstructured open ecosystem rooted in different parts of the world remains one of the biggest challenges.

In the long run, allowing the supply side to scale horizontally is the appropriate solution without significantly impacting the trust requirements of layer 1 systems. After all, users want low fees, and low fees are not an economic mechanism design problem, but a fundamental blockchain scalability problem. Notably, scalability will also allow more demand to enter the system, which will offset the decline in average fees per transaction. The main approaches here are so-called layer 2 solutions such as Optimistic and ZK rollps.

Dark Forest and Dark Pool

If we were in the context of Bitcoin, the discussion around the demand side would end here. However, in Ethereum, an entire financial system is being built that distorts the rules of the game. There may be certain "opportunities" in the Ethereum network that exist in the form of arbitrage or when a high-demand asset is sold with limited participation (such as an ICO). Similar to people lining up to buy limited edition clothing, developers have built software that intelligently competes for opportunities on the chain, even competing with other bots through gas bidding.

This concept is called the Priority Gas Auction (PGA) and was first proposed in the seminal paper "Flash Boys 2.0" by Phil Daian et al. The "irregular" income stream generated by the PGA is called Miner Extractable Value or MEV. Bots participating in the PGA have access to a potentially very profitable opportunity and are willing to pay a high price for gas fees, up to the maximum profit they want to make.

In Ethereum is a Dark Forest, the author describes an extraction of approximately $12,000 worth of tokens into the hands of “scrappers.” These scrappers are arbitrage bots that constantly monitor activity on the mempool and attempt to front-run specific types of trades based on predetermined algorithms. DEX platforms such as Uniswap are likely rife with arbitrage bots.

As a result, some service providers began offering "Dark Pools" - transactions that bypass the public memory pool and are therefore not visible to the public until they enter the chain. Instead of broadcasting to the network, these Dark Pools forward transactions directly to miners so that they are not broadcast to other nodes on the network. These Dark Pools are not entirely used for profit maximization purposes. In "Escaping the Dark Forest", security researcher samczsun documented how his team used this technique to save 25k ETH from a flawed smart contract.

Front-running and dark pools are not unique to the cryptocurrency market. They represent an age-old driving force in finance: secrecy. Wall Street has long embraced this controversial approach. It is estimated that after 2015, dark pool trading accounted for 15-18% of US listed securities trading activity.

The "total potential market" of MEV is growing exponentially, with at least $350 million of MEV extracted since the beginning of 2020, one-third of which occurred in February 2021. Most of the extracted MEV is concentrated in arbitrage between popular automated market makers such as Uniswap, Sushiswap, Curve, and Balancer. In addition, liquidations on Compound and Aave also account for a small part.

The butterfly effect is amazing: arbitrage and liquidation opportunities create MEV. MEV competes through PGA. Fee estimators use gas fees inflated by PGA as a reference, causing users to overpay for their transactions. The core of the problem is that users and bots are in the same transaction pool regardless of whether they pursue MEV or not.

Ideally, MEV transactions should be in a separate transaction pool from non-MEV transactions. This allows robots that extract MEV to compete with each other, while all other transactions (such as transferring a CryptoPunk) will be carried out in the non-MEV transaction pool, which will allow users to enjoy a more stable Gas market.

Unfortunately, this kind of massive change to Ethereum is difficult to execute. A simpler way to solve this problem would be to introduce a new API endpoint for miners, where they would accept bundles with only MEV transactions. That way, traders would submit transactions directly to the terminal, while users continue to use the rest of the system as they do today. This is the approach taken by Flashbots, and as far as we know, it is the least disruptive approach.

How will miners adapt to MEV?

In the past, when fees were a negligible percentage of total block rewards, the main focus of miners was to get as much share of the block as possible. Miners would often choose a pool with enough hashrate to host their hashrate. After years of development, the mining pool infrastructure has been more or less optimized to the same performance range. A group that lags behind its peers will be easily discovered and quickly eliminated by competitors. Miners don't really care which mining pool they use, except for basic parameters. Users don't really care which mining pool processes their transactions, and mining pools don't care who the users are as long as the fees are attractive. But as MEV grows relative to block rewards, the considerations of miners, mining pools, and users begin to become more nuanced.

With MEV, the block space market mechanism will change from a pure commodity market to include some elements of a matching market. When users submit transactions, they should be aware of the mining pool's ability to execute the transaction in a timely manner.

All else being equal, MEV will result in higher gas fees than they would have been without MEV. This means that miners are already indirectly extracting a small portion of the total MEV extracted by transactors, currently estimated at around 12%. A recent analysis also suggests that fees earned from MEV will eventually exceed fees earned from "regular" revenue streams. That said, miners are profit-seeking entities who may wish to extract more MEV. By leveraging their power over transaction ordering, miners can choose to insert, reorder, or even censor transactions in order to maximize the profits of their transaction operations.

In extreme cases, miners will reorganize the blockchain over and over again due to attempts to extract MEV from past blocks (commonly known as a "time bandit" attack). While possible, this scenario is clearly unfeasible: miners are (in most cases) structurally long ETH, and this action will directly negatively impact their ETH investment.

A more optimistic view is that miners decide to outsource MEV extraction to traders. They can adopt the Flashbots approach mentioned above, retaining the block rewards and outsourcing the orders, or renting out the hash rate to specialized trading companies.

Whichever approach is adopted, we expect that Ethereum mining pools will inevitably begin to become more active in the MEV extraction process. As the MEV extraction race heats up, it remains to be seen how this market structure change will affect Ethereum's (de)centralized mining ecosystem.

How do other users of the ecosystem participate in MEV?

The financialization of hashrate is an important trend in the mining space. If block space is analogous to real estate, then hashrate is the equity in the property, and a forward contract for hashrate is analogous to a mortgage. For miners, selling hashrate through hashrate tools is a way for them to lock in future revenue. Similar to renting hashrate on a cloud mining platform, a forward contract allows miners to sell a fixed amount of hashrate for a prepaid price over a period of time.

Active DeFi users who anticipate an increase in network MEV activity can speculate by purchasing these hashrate tools. For example, a trader who anticipates a surge in network MEV activity over the next 15 days can purchase x amount of hashrate at a prepaid price over the next 15 days. During the contract period, the mining rewards plus the MEV income extracted by the miner will then be transferred to the trader. If the trader is in a favorable position, the purchase may earn back the MEV fees that the trader himself paid to the mining pool. Both Liquid Hashrate Tools and MEV represent cutting-edge developments in the mining capital market. New tools are being actively built to move in these directions. MEV+Hashrate Tools complete a full circle for users and miners.

in conclusion

The structure of the Ethereum blockspace market is a fascinating research topic. In this analysis, we observed key differences between the supply side of the GPU and ASIC hashrate markets. We also identified key mechanisms that create demand-side dynamics. We then combined these two and placed them in the context of the value that miners can extract.

As Charlie Noyes wrote in MEV and ME: "Any attempt to prevent miners from receiving revenue streams is likely to spur the creation of non-protocol markets." MEV is the inevitable result of the increasing complexity of Ethereum transaction types. As MEV tools and knowledge bases become more mainstream, more interesting MEV patterns will emerge. These behaviors will profoundly affect the frequency with which DeFi users plan block space purchase strategies.

Changing the way goods are sold in the market will also change the way goods are produced. MEV creates new revenue channels for mining, which in turn will affect the way the mining industry interacts with block space buyers. New patterns will emerge in the Ethereum mining cycle.