Overview:
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History has shown that derivatives can strengthen the spot market and provide additional tools for stakeholders in the supply chain to manage their business. Similarly, the Ethereum spot gas market may also benefit from the derivatives market.
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With the development of Ethereum gas derivatives, we have the opportunity to develop a whole set of products to provide a better user and developer experience (for example, users and developers can expect or rely on a fixed gas price without worrying about price fluctuations), and improve the efficiency of Ethereum block space price discovery. In addition, in most markets, the trading volume of derivatives far exceeds that of spot, which provides important opportunities in a wide design space.
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When designing these products, legal/regulatory, market, and protocol-specific issues need to be considered. In addition, the sophistication of market participants must be increased to support active trading of these products.
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Although it is difficult to know when this market will develop, some favorable conditions are emerging, such as the concentration of gas buyers (that is, due to the development of L2/account abstraction), the increase of hedging products (such as pledging products), and the improvement of the sophistication of various stakeholders in the trading supply chain (such as through infrastructure improvements).
Throughout history, examples of commodity markets being more volatile due to external events are numerous. Although factors outside the market help reduce the risk of commodity production and consumption companies (for example, globalization brings more efficient shipping/transportation and networking), derivatives can serve as a more comprehensive price discovery tool. In addition, derivatives can be used to better manage businesses that depend on commodities (such as oil companies, precious metals, and agricultural products). There are similar opportunities in the Ethereum block space, and with the development of block space derivatives, stakeholders can provide a better user experience, have more tools to manage their business, and increase the efficiency of block space price discovery. Below we provide an overview of the current state of the Ethereum block space, historical analogies to traditional markets, and attempt to show key considerations for developing a block space derivatives market based on other people’s research.
Introduction to Ethereum Block Space
Ethereum’s business model revolves around the sale of block space (blocksBlockingce). Block space is utilized by various participants to interact with smart contracts that drive applications, support additional infrastructure layers, or directly complete transactions. However, like most resources, the supply of block space is limited. To determine who or what can consume this supply, Ethereum introduced Gas (the transaction fee paid on the blockchain network, called Gas). Gas is used by various parties to specify how much they are willing to pay to have their transaction included.
Gas and its use in Ethereum have evolved, with the most recent key changes occurring in August 2021. With the implementation of the London hard fork and EIP-1559, Ethereum’s fee market transitioned to one composed of a burned base fee and a tip given to validators. After this change, the market now has a protocol-driven base fee as a reference rate and ensures that the minimum cost for including transactions in a block is realized.
In September 2022, “The Merge” happened! Although subtle, this also changed some dynamics related to any potential derivative markets. After the merge, validators responsible for proposing the ultimately finalized new block are known two epochs ahead of time, giving the market approximately 12 minutes to know who will stack the next block (this could have interesting implications for potential physical delivery markets).
Finally, in the short term, the community may introduce a new, data storage-related fee market. Known as EIP-4844, this market will be Ethereum’s first multi-dimensional fee market, separating data storage from execution. The impact of this and other roadmap projects will be discussed below.
What We Can Learn From Other Commodity Markets
To begin understanding the potential design and market structure of block space derivative markets and their possible impact on spot markets, we surveyed traditional markets and observed various attributes. Here are several key characteristics we identified in the most comparable markets:
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Non-tradable underlying: Gas in Ethereum is not directly tradable in its current form; we looked for markets based on non-tradable underlying indices.
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Cash vs. Spot: Given the different dynamics between physically delivered block space and cash exchanged at expiration, we looked for derivative markets that settle cash at expiration, while spot markets are physically delivered.
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Stakeholders: Significant activity and speculation require actual use of the commodity/commodity driving it.
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Microstructure of the market: The position of a transaction in a block can have a significant impact/greatly change the price that buyers are willing to pay. Therefore, we looked for markets that exhibit similar microstructure dynamics driven by quality/geography/other indicators.
We found that based on these factors, the most relevant markets are oil and VIX (Volatility Index, which reflects the degree of fluctuation in the market and indicates the level of panic). More details are discussed below, but it is important to note that both of these markets have been widely used by various stakeholders to achieve a range of goals (i.e., better business management, hedging, observation, etc.).OilUntil the 1980s, the oil market was essentially dominated by a small number of market participants, mainly oil-exporting countries. By the end of the 1980s, a healthy spot market had developed, gradually replacing fixed-term pricing contracts. However, even with this development, there was still a problem – this market required physical delivery. Given the complexity of delivering oil, these markets continued to be dominated by a few long-term partners rather than being open to a wider range of participants.As these markets continued to mature, benchmarks such as West Texas Intermediate (WTI) were developed to track overall spot prices from certain regions. This allowed markets and other stakeholders to support and exchange oil in a standardized way (i.e., you don’t need to know the subtle differences of regions or markets to trade oil). Through this development, not only were more actors able to understand prices, increasing the liquidity and depth of the market, but derivatives can now be developed on this index (most of which are cash-settled). The result is that more stakeholders can participate in price discovery, which can be said to improve efficiency, and provide producers and consumers with more powerful tools to manage their business. Currently, the trading volume of WTI and Brent futures contracts on the ICE and NYMEX exchanges can reach billions of barrels per day, while global oil demand is about 100 million barrels per day; futures trading volumes are more than 25 times daily oil consumption.
Volatility Index / VIXThe VIX market originated from financial economics research in the late 1980s and early 1990s, proposing a set of volatility indices that can serve as the underlying asset for futures and options trading. The role of the volatility index is similar to that of the market index, and traders can speculate on a group of stocks or, in the case of VIX, speculate on the underlying volatility of a broader market. This allows participants to speculate on future market uncertainty and hedge against increased volatility when the market falls, which may cause losses in investors’ equity portfolios. However, unlike equity indices, VIX itself cannot be traded. Therefore, only derivative products based on cash settlement of VIX can be traded. Nevertheless, since its launch in 2004, the average daily trading volume of the VIX futures market has increased from about 460 contracts to about 210,000 contracts in 2022. This market structure is similar to the current Gas market. The underlying Gas cannot be traded, but it is observable and quantifiable properties of the Ethereum block space market. Therefore, creating a standardized Gas reference price is necessary for cash settlement of futures/options/swaps/ETPs. Fortunately, since EIP-1559, this task has become easier because it can serve as a reliable oracle about block space congestion.
Factors to consider when designing a product
While we can extract information from historical analogies to show how the derivatives market may impact the stability of the Ethereum block space market, the Ethereum block space has unique characteristics that will also determine how reference benchmarks and derivative products are designed. We believe the following should be the primary considerations for anyone looking to develop markets/products. These are broken down as follows:
– Market structure: This section covers considerations around block space/Gas market participants, the ability for price makers to effectively hedge, consolidation of potential buyers, reference rate design, regulation, and a variety of other considerations.- Protocol/Roadmap: This section covers considerations around the complex spot Gas market, block space differentiation, and other considerations, as well as potential roadmap considerations for future projects.- Cash and physical settlement: Defines cash and physical settlement and discusses potential design considerations for physical settlement of block space.
1. Market structure
Block space/Gas market participants: In such a market, there are price takers and price makers:
– Price takers need to interact with the market to manage risk in their business. Going back to the oil market, this includes both oil producers and subsequent supply chain participants involved in refining or commercial use of oil. Similarly, in the Gas derivatives market, there are validators who supply block space, but subsequently there are applications/users who require block space. These participants may want to secure fixed income for block space in advance, while applications/wallets may want to secure predictable fixed costs for their future block space needs.- These participants ultimately want to avoid exposure to dynamic price movements in the spot market, but this forms two opposing sides: – Short: One party commits to selling block space in the future at a currently agreed upon price, and faces the risk of pre-selling future block space at too low of a price. – Long: One party commits to buying block space in the future at a currently agreed upon fixed price, and faces the risk of overpaying for future block space.
Price makers are market participants who speculate and bear pricing risks. In traditional markets, these roles are played by market makers in banks, asset management companies, high-frequency trading entities, etc. These participants are crucial for creating more liquid and efficient markets. In the Gas market, we see this role being played by digital asset market makers, investment firms, and, in the long run, validators themselves. However, price makers are still lacking in the market, mainly due to the lack of a sufficiently liquid spot market to hedge against block space risk.
Price makers cannot hedge effectively: The auction mechanism that drives the base fee for block space can be manipulated (especially in the short term), and tips can be unlimited. As shown in the figure below, the average gas price is highly volatile, and volatility would be even greater if observed block by block.
These factors pose significant risks to price makers as they expose themselves to unlimited and variable costs for block space. Some issues can be smoothed out by using time-based metrics (to reduce the impact of a single cost increase on the reference rate) or other investment products that limit losses / gains. However, these methods have trade-offs, and they may not meet the needs of sellers / buyers and typically reduce the hedging effectiveness of derivatives for long/short positions. Given this, we expect validators, block builders, and searchers to play the role of launching market shorts at the beginning because they have natural supply or the ability to acquire physical block space, existing optimization and utilization of block space supply, and experience in managing block space risk.
Concentration of buyers: With the development of L2 and the likelihood that most users will access block space through rollups rather than L1, we expect buyers of L1 block space to be centralized through L2 operators / people who complete L2 transactions on L1. Outside of L2, we expect further concentration of block space buyers to shift towards infrastructure and actors that make users not directly buy block space, such as block builders/AA (account abstraction) / MPC (decentralized private key storage technology) + middleware. Designing products for these stakeholders, rather than individual consumers with broad targets and needs, should help narrow down product design.
Reference interest rate design: If the product is cash-settled, the reference interest rate is an important design feature of a thriving market, and this design needs to balance multiple factors.
2. Agreement/Roadmap
Complex spot Gas market: As part of EIP-4844, Ethereum’s first multi-dimensional fee market appeared in history. This market creates two prices for Ethereum block space – one for data and one for execution. These two spot markets will use independent but similar pricing/auction mechanisms. However, because data block space consumers and execution block space usage are different, there may be price differences between these two markets. Therefore, anyone designing block space derivatives may need to consider this and may provide interesting hedging/trading opportunities for buyers/speculators and risk managers between these two markets based on the development of EIP-4844 after the spot market. Additionally, although it is still early, community researchers have mentioned further fee market splits that will create additional microstructures.
Differences in block space: Not all block spaces are homogeneous. For example, there are block congestion, which covers block space that users only need to pay fees to include. Then there is competition, where users pay fees to indicate they want to be included in the block in a certain order. Considering consumer behavior in each microstructure, derivatives may need to consider these dynamics or be designed for these specific participants. Although this is difficult to estimate, we have looked at the quantity and quality of resources to understand where historical user preferences are to help understand where recent and long-term opportunities may lie.
In the above figure, we can see that some users are willing to pay exponentially higher prices for block space at the head and tail of the block (i.e., competition), but most users only pay for inclusion (i.e., congestion). A leading researcher at the Ethereum Foundation recently speculated that many users prioritize congestion over competition. Although there may currently be a market related to competition, based on the above and other MEV-related dynamics, we expect the largest block space derivatives market to focus on congestion in the long term.
Considerations for various other issues: In addition to the above, there are other considerations that may affect the derivatives market. These include forks and probabilistic finality, confirmation rates (low confirmation rates lead to congestion and slow network processing of blocks), and audits that may be performed by block builders and/or validators.
Further development: Although it may take a few more years, there will be further dynamic impacts on block space and any derivative products. Besides EIP-4844, we believe the most relevant and most closely watched changes are MEV-Burn, any form of validator cap/staking economics changes, the finality of individual transactions, and ePBS (Block unicorn note: short for Ethereum Proof-of-Broadcast Space. This is a new consensus algorithm that aims to improve the efficiency and security of block propagation while considering network delays and broadcast costs. In the ePBS mode, validators no longer produce blocks solely based on their stake holdings, but instead based on their position and performance in the network. This can make block production and propagation more fair and effectively prevent network attacks).
Block unicorn note: MEV-Burn is only part of the direct solution to the MEV problem in the Ethereum roadmap. This solution returns MEV to ETH holders by burning the value currently extracted by MEV participants. This indirectly reallocates value to ETH holders, making assets scarcer and reducing selling pressure on block validators.
3. Cash Settlement vs. Physical Delivery
Gas derivatives can choose to settle in “cash” or through “physical delivery”. More details below, but generally, cash-settled products cannot fully replicate the deliverable spot market as they offer synthetic exposure to the commodity, usually based on a reference rate. Therefore, the existence of derivatives mechanisms that settle through physical delivery is crucial. It ensures that a broader block space derivatives market accurately reflects the conditions of the deliverable spot market.
Physical delivery: Compared to the cash market, physical delivery in Ethereum block space (and indeed any commodity market) is more complex. When derivatives expire, both parties to any such derivative must physically settle the goods. For the case of a validator transacting with an application, this means that the validator must provide block space to the buyer. We discuss several possible ways of physically delivering block space below:
Block builders provide this service: As previously discussed, block construction is likely to continue to be dominated by a few participants due to economies of scale and technical requirements for full depth sharding, who have good standing in these markets. Block builders are obviously the natural buyers/sellers of block space (after all, they are in the business of managing/optimizing block space), and can also provide physical delivery of block space services to block space applications/consumers.
Validator Coordination/Middleware: In addition to block builders, validators are also key stakeholders in the physical delivery market of block space. This will be driven by a desire of validators who wish to help manage revenue volatility in the current validation business and allow for the development of new markets where validators can sell future block space at a premium.
On the Issue of Block Space Derivatives We recognize that there have been multiple attempts at hash rate derivatives around the Bitcoin network. These markets have seen some growth but are currently limited. While these markets may be ahead of their time, market structure friction around hash rate derivatives do not exist in the potential Ethereum block space market – most importantly a wider range of natural market participants increases the possibility of liquidity and bilateral market growth. However, we also acknowledge that it is still too early. After all, futures trading volumes in more mature Ethereum markets are still overshadowed by traditional commodity markets’ derivatives trading volumes. Additionally, to make this market thrive, roles like block builders, validators, and applications need to become more proficient, with competition between these participants becoming so fierce that teams use these products to gain competitive advantages over each other, or can offer unique products that heavily rely on managing future block space.
While this opportunity is in our minds, we believe that block space futures may have a unique impact on Ethereum, helping stakeholders better address Gas and block space-related issues. We hope this post will inspire a wave of related discussions, developer musings, some hackathon projects, and innovations that will emerge over the next decade.
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