Business of Block Space Pt. 2: Mevconomics
Introduction
We previously argued in our piece, The Business of Block Space, that the sale of block space is one of four blockchain/crypto market segments which generates repeatable, robust product-market fit. Over time we expect it to be the market segment which generates the 2nd most Gross Profit after exchanges, or even become #1 as trading volumes shift from CEXs to DEXs. It’s a business-to-business-to-consumer (B2B2C) model where blockchains court application developers who in turn court consumers — both individuals and enterprises — to consume block space via their application.
We also argued that block space is a network effect-based business, in contrast to its cousin business model, centralized cloud computing which has economies of scale but not network effects. Network effects in blockchains exist around (i) application developers, (ii) application deployments, (iii) users, (iv) liquidity in protocols, and (v) raw capital.
Galaxy predicts that the consumption of block space (from the perspective of aggregate dollars spent to consume block space) will accelerate over time, with any future increases in capacity being filled by induced demand.
Mevconomics
In this piece, we’re going to evaluate what percentage of block space is consumed by MEV transactions and discuss why it matters for the evaluation of block space as a business model.
MEV transactions are categorically different from non-MEV transactions. Demand for MEV comes from inside the system (endogenous) while demand for non-MEV transactions comes from outside the system (exogenous). MEV is a magnification of block space demand – it is only created from use of the system by others.
Non-MEV Transactions: A user is willing to pay for this because of their exogenous demand to use an application, like paying for a stablecoin transaction or depositing into Compound.
MEV Transactions: A user is able to earn a riskless profit (or a statistically riskless profit) as a result of the state of the system. Demand to consume block space that is created by the exogenous demand to use the system. In other words, endogenous demand.
In my ongoing study of block space as a business model, it’s worthwhile to consider how much demand is contributed by MEV.
So how much demand is contributed by MEV?
MEV is a Driver of Block Space Demand
From my Business of Block Space piece, the total demand for block space on the top fee-generating chains is in the billions per year and heavily power-law distributed:
The timeseries of Daily Fees Paid since Sep. 2022 is shown below on Log Scale:
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 reasonably good public MEV data — through the end of February 2024 allocated between MEV Searcher profits, Validator Tips, and Burned ETH. These numbers do not include DeFi-CeFi arbitrage which is statistical in nature rather than atomic and is conducted both on-chain and off-chain.
Searchers find MEV opportunities and pay transaction fees to get their opportunities included. Competition among searchers forces them to pay more in Transaction Fees than normal blockchain transactions to ensure inclusion, and so of transaction fees paid for MEV, most of it ends up in the Validators’ pockets and reflected as marginally higher yield on staked ETH (Fig: Weekly MEV Supply Chain - black bar). Some of it ends up burned and contributed to ETH holders in the form of a Burn (Fig: Weekly MEV Supply Chain - orange bar) under EIP-1559. And some ends up as profit margin for Seachers’ work. The full MEV Supply Chain averaged $6.6M per week in income in 2023, with spikes to over $20M per week (excl. CeFi-DeFi arbitrage conducted by builders).
MEV by Strategy
Different MEV strategies have different payoff and margin profiles. The data suggests that sandwiching, which is a parasitic form of MEV that involves both front-running and back-running casual DEX users, generated $212M in revenue last year on Ethereum. Atomic Arbitrage, which is more beneficial as it has the effect of equalizing prices across DEX pools, generated $126M in topline revenue in 2023. Liquidation — the reward for clearing out bad debt from lending protocols like Maker, Aave, and Compound — generated only $7M in 2023. Other forms of MEV exist but are more bespoke than systematic.
CeFi-DeFi arbitrage is a harder nut to crack and there are no public figures that quantify how much is made on CeFi-DeFi arbitrage (because the CeFi leg is dark). Galaxy proprietary tracking shows that CeFi-DeFi arbitrage earned about $98.5M in 2023 but only representing ~60% of market share. This is based on simulations against CeFi tick data but could be higher or lower depending on specific Builder strategies. Beware that the CEX-DEX arb has a large confidence interval around it.
More interestingly, the Gross Margins of the different strategies shows which generates more profit to Ethereum/validators vs. which generates more profit for Searchers. Arbitrage and Sandwich generated just 18.6% and 14.2% gross margins which means those strategies are (i) hypercompetitive and (ii) they accrue more value to the base layer in Fees. Meanwhile, Liquidation generated 51.1% Gross Margins but does not have meaningful scale so it is less competitive (and less relevant in the discussion). CeFi-DeFi Arb has scale and is less competitive due to deeper fundamental moats around Order Flow, Builder Concentration, and general Stat Arb sophistication.
MEV has a Stationary Relationship with Block Space Demand
MEV as a percentage of transaction fees paid is neither rising nor falling over time. Based on Fig. Arbitrage Payoff by Week, the amount of MEV in each week as a percentage of block space hovers around 10%. In volatile weeks like the collapse of FTX, that percentage can rise to 30% of transaction fees. The week of the SVB crisis also had MEV hit 25% of transaction fees. It’s a mean-reverting time series (much like volatility in financial markets). In fact, MEV activity is presumably closely correlated with volatility itself.
Put another way, if there is $100M of transaction fee consumption in a given week, we can predict on average that 90% came from exogenous demand to use an application and 10% was created endogenously due to riskless profits made available by that week’s state changes. If 30% is created by MEV and 70% by non-MEV, it’s fair to believe that next week will witness a return to norm. We’ll watch this closely to see how it changes over time.
It should be noted that this invariance around 10% is particular to financial applications on blockchains (DEXs and lending protocols). Those applications generate MEV, rather than stablecoin applications or gaming. If the predominance of financial applications secularly falls, MEV’s relevance should fall too assuming no new forms of stablecoin or gaming MEV are discovered.
Summary: MEV Plays a Lesser Role Today, but a Large One in the Future
While MEV has the power to corrupt protocol incentives and is an unassailable consumer of block space, the actual financial contribution of MEV to Ethereum today is relatively muted at only 10% of transaction fees. Weeks with black swan market events like FTX or SVB can see that rising to 25% or higher, but that is the exception not the norm and historically has reverted back to a consistent place. What is the role of MEV in the business model of block space then? In some ways it is a demand multiplier effect, taking the exogenous demand to use applications and multiplying it by 1.1 - 1.3x.
All that said, the role of MEV on future block space consumption is likely very material. Blockchains like Solana and Monad (Galaxy Ventures portfolio company) will have much cheaper fees per transaction. MEV will likely be a larger percentage consumer of block space on low fee chains than on high fee chains like Ethereum. To illustrate with a toy example:
The most profitable blockchains in the future will likely be those which both: (a) reduce transaction fees and induce demand for network activity and (b) capitalize on network activity primarily in the form of validators/sequencers/burn capturing MEV.
The existence of a phenomenon like MEV is just another reason why block space is a never-before-seen business model. Its unique brew of traits leads to being a good business model and one worth investing behind over the long term. As a final note, we reiterate our fluid list of block space strengths and weaknesses:
Strengths:
Strong Net Income Margins. The sale of block space is the only business model with Zero OpEx. Every cost is a direct cost in the production of block space and registered as COGS. Ethereum has a fluctuating Net Income margin, but it has averaged 33.9% Net Income Margins since Jan 2023.
Prone to Network Effects. Generally, SaaS products don’t have a network-effect business, while social media applications and marketplaces do. Block space improves as more applications and capital onboard, driving sustainably higher Tx. Fees for those with network effects. A network effect can accrue additional revenue via MEV.
Increasing Scale over Time. Some block spaces will benefit from increasing scale, like L2s, which have capacity for further scale.
Exogenous Demand Multiplier Effect from MEV. MEV is an ever-present feature of blockchain systems. MEV – while it can harm consensus – contributes fees to an ecosystem at scale. For every $1 of Transaction Fees on Ethereum, there is ~$0.10-0.30 of MEV fees.
Weakness:
Low, but Improving Gross Margins. The cost to produce a unit of block space (say, 1M gas) is high and can require 66%+ of the future profits from that block space. Block space is a low gross margin business.
High Cyclicality. Revenue from selling block space is highly cyclical. It depends on market conditions and often correlates heavily with market volatility.
Credit to Flipside and LibMEV for the data.
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