Author: Will Nuelle, Partner at Galaxy Ventures
Translated by: Luffy, from Foresight News
Introduction
In our previous article on “Block Space Business Models,” we pointed out that block space sales are one of the four niche markets in the cryptocurrency market, which can generate a repeatable and robust product-market fit. Over time, we anticipate that block space will become the second largest profit-generating niche market after exchanges, and may even become the largest profit market as trading volume shifts from CEX to DEX. This is a B2B2C business model, where blockchain attracts application developers, who in turn attract consumers (including individuals and businesses) to use block space through their applications.
We also believe that block space is a network effect-based business, contrasting sharply with centralized cloud computing in similar business models, which have economies of scale but lack network effects. Network effects in blockchain exist in (i) application developers, (ii) application deployment, (iii) users, (iv) protocol liquidity, and (v) original capital.
Galaxy predicts that block space consumption (the total amount spent on consuming block space) will accelerate over time, and any increase in blockchain capacity in the future 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 assessing block space as a business model.
MEV transactions are fundamentally different 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 block space demand, generated solely by others using the system.
Non-MEV Transactions: Users are willing to pay for this because they have an exogenous demand for using applications, such as paying stablecoin transaction fees or depositing in Compound.
MEV Transactions: Users can profit risk-free (or statistically risk-free) based on the system’s state. The demand for consuming block space is created by the exogenous demand for using the system. In other words, it is endogenous demand.
In my research on block space as a business model, I have been pondering: how much demand does MEV contribute to it?
MEV is a driving factor of block space demand
From the previous article on “Block Space Business Models,” it can be seen that the total demand for block space on top-tier fee-charging blockchains amounts to billions of dollars annually, and follows a power-law distribution:
Source: Will Nuelle, Galaxy Ventures
Since September 2022, the daily transaction fees paid by users are as follows (the time series is displayed on a logarithmic scale):
Source: Will Nuelle, Galaxy Ventures
MEV is a permanent feature of blockchains 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 figures do not include DeFi-CeFi arbitrage, which is essentially statistical rather than atomic and conducted on-chain and off-chain.
Source: Will Nuelle, Galaxy Ventures
Searchers look for MEV opportunities and pay transaction fees to have a chance of their inclusion in a block. Competition among searchers forces them to pay higher transaction fees than normal blockchain transactions to ensure inclusion, with most of the fees paid for MEV going into validators’ pockets, resulting in validators earning slightly higher profits than staking ETH. Some of it is burned according to EIP-1559, ultimately benefiting all ETH holders; while some becomes profits for the searchers’ work. In 2023, the full MEV supply chain averaged weekly revenues of $6.6 million, peaking over $20 million in May (excluding CeFi-DeFi arbitrage earnings).
MEV Strategies
Different MEV strategies have different returns and profit margins. Data shows that sandwich trading is a parasitic form of MEV that generated $212 million in revenue on Ethereum last year by front-running and back-running careless DEX users. Atomic arbitrage is more advantageous as it balances the prices in the DEX pools, resulting in a total revenue of $126 million in 2023. Liquidation (clearing bad debts in lending protocols like Maker, Aave, and Compound) only generated $7 million in revenue in 2024. Additionally, there are other forms of MEV, but they are more customized rather than systemic.
Source: Will Nuelle, Galaxy Ventures
CeFi-DeFi arbitrage is a more difficult-to-quantify strategy, and there is no public data available to quantify the earnings from CeFi-DeFi arbitrage (as the CeFi part is opaque). Data tracked by Galaxy shows that CeFi-DeFi arbitrage earned approximately $98.5 million in 2023, but only accounted for about 60% of the market share. This is based on simulations of CeFi quoting data, but it could be higher or lower depending on specific builder strategies. Note that there is a wide confidence interval for CEX-DEX arbitrage.
Interestingly, the gross profit margins of different strategies indicate which strategies can bring more profits to Ethereum/validators and which strategies can bring more profits to searchers. The gross profit margins of arbitrage and sandwich strategies are 18.6% and 14.2%, respectively, meaning that these strategies (i) are competitive, (ii) accumulate more value at the base layer (Ethereum) in terms of fees. Meanwhile, although the liquidation strategy has a gross profit margin of 51.1%, it is difficult to scale, making it less competitive (and less important in this discussion). CeFi-DeFi arbitrage has a certain scale, but due to deeper moats in terms of order flow, builder concentration, and general statistical arbitrage complexity, it is less competitive.
Source: Will Nuelle, Galaxy Ventures
Source: Will Nuelle, Galaxy Ventures
There is a stable relationship between MEV and block space demand
The percentage of MEV as a payment of transaction fees remains stable over time, neither rising nor falling. As shown in the chart above, the percentage of MEV relative to block space hovers around 10% on a weekly basis. During weeks with significant price and volume fluctuations, such as the FTX collapse, this percentage may rise to 30% of transaction fees. During the Silicon Valley bank crisis week, MEV also reached 25% of transaction fees. This is a highly volatile mean-reverting time series, much like financial markets. In fact, MEV activities may be closely related to volatility itself.
Source: Will Nuelle, Galaxy Ventures
Source: Will Nuelle, Galaxy Ventures
In other words, if transaction fees consumed in a week amount to $100 million, we can predict that 90% of it comes from exogenous demand for using applications, while 10% is internally generated due to risk-free profits from changes in the state that week. If 30% is created by MEV and 70% by non-MEV, then it is reasonable to believe that next week will likely return to normal. We will closely monitor this situation and see how it changes over time.
It is worth noting that this approximately 10% stability only applies to financial applications (DEX and lending protocols) on the blockchain. These applications generate MEV, unlike stablecoin applications or games. If the dominance of financial applications declines in the long term without the discovery of new forms of stablecoin or game MEV, the relevance of MEV will also decline.
Conclusion: MEV currently plays a minor role, but will play an important role in the future
While MEV has the ability to disrupt protocol incentives and is a permanent consumer of block space, its actual financial contribution to Ethereum is relatively small, accounting for only 10% of transaction fees. During weeks with black swan market events like FTX or Silicon Valley bank, this ratio may rise to 25% or higher, but this is an exception rather than the norm, and historically, this ratio has returned to a stable state. So, what role does MEV play in the block space business model? In some ways, it is a demand multiplier, multiplying the exogenous demand for using applications by 1.1-1.3 times.
Nevertheless, the impact of MEV on future block space consumption may be significant. Blockchains like Solana and Monad have much lower transaction fees per transaction, and the proportion of block space consumed by MEV on low-fee chains may be higher compared to high-fee chains like Ethereum. Let’s illustrate this with a simple example:
Source: Will Nuelle, Galaxy Ventures
The most profitable blockchains in the future are likely to be those that have the following characteristics simultaneously: (a) lower transaction fees and stimulate network activity demand, and (b) primarily utilize network activity in the form of validators/sorters/burns capturing MEV.
The existence of MEV and similar phenomena is just another reason why block space is becoming an unprecedented business model. Its unique characteristics make it a promising business model worth long-term investment. Finally, we reiterate the advantages and disadvantages of block space:
Advantages:
Strong net income profit margin. Block space sales are the only business model with zero operating costs. Ethereum’s net income profit margin has fluctuated significantly, but since January 2023, its average net income profit margin has been 33.9%.
Easy to generate network effects. Generally, SaaS products do not have network effects, while social media applications and markets do. With more applications and capital joining, block space is improving, continuously driving up transaction fees with network effects that can generate additional income through MEV.
Block space scales over time. Some block spaces will benefit from scale, such as L2, with further growth potential.
MEV’s exogenous demand multiplier effect. MEV is a characteristic that has always existed in blockchain systems. While MEV may potentially harm consensus, it contributes significantly to the ecosystem. For every $1 of transaction fee on Ethereum, approximately $0.10-0.30 of MEV fee is generated.
Weaknesses:
Low gross profit margins, but improving. The cost of producing a block space unit (e.g., 1M gas) is high and may require over 66% of the future profits of that block space. Block space is a low gross margin business.
Strongly cyclical. Income from selling block space has strong cyclicality. It depends on market conditions and is often closely related to market volatility.
Original article link
