Original Author: Will Nuelle, Galaxy Ventures General Partner
Translated by: Luffy, Foresight News
Introduction
In our previous article “Business Models in Block Space,” we pointed out that block space sales are one of the four submarkets in the cryptocurrency market, which can generate a repeatable and robust product-market fit. Over time, we expect block space to become the second largest profit-generating submarket after exchanges, and with the transfer of trading volume from CEX to DEX, it may even become the largest profit market. This is a B2B2C business model, where blockchain attracts application developers, and application developers 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) liquidity in protocols, and (v) original capital.
Galaxy predicts that the consumption of block space (measured by 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 consumption 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 external demand for using applications, such as paying stablecoin transaction fees or depositing in Compound.
MEV transactions: Users are able to make risk-free profits (or statistically risk-free profits) based on the system’s state. The demand for consuming block space is created by the external demand for using the system. In other words, it is endogenous demand.
In our research on block space as a business model, I have been pondering: How much does MEV contribute to this demand?
MEV is the driving force behind block space demand
As seen in the previous article “Business Models in Block Space,” the total demand for block space on top-fee blockchains amounts to billions of dollars annually, and follows a power-law distribution:
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Source: Will Nuelle, Galaxy Ventures
Since September 2022, daily user payments for transactions have been as follows (time series shown in logarithmic scale):
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Source: Will Nuelle, Galaxy Ventures
MEV is a permanent feature of blockchain and a permanent consumer of block space. The chart below shows MEV on Ethereum (the only chain with good public MEV data) until the end of February 2024, distributed between profits for MEV searchers, validator tips, and ETH burned. These figures do not include DeFi-CeFi arbitrage, which is essentially statistical rather than atomic, and occurs on-chain and off-chain.
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Source: Will Nuelle, Galaxy Ventures
Searchers seek MEV opportunities and pay transaction fees to get a chance to include them in blocks. Competition among searchers forces them to pay more transaction fees than normal blockchain transactions to ensure inclusion, therefore, most of the transaction fees paid for MEV end up in the validators’ pockets, resulting in validators earning slightly higher profits than staking ETH. Part of it is burned according to EIP-1559, benefiting all ETH holders in the end; and some becomes profits for the work of searchers. In 2023, the complete MEV supply chain averaged a weekly income of $6.6 million, peaking at over $20 million in May (excluding profits from CeFi-DeFi arbitrage).
MEV Strategies
Different MEV strategies have different returns and profit margins. Data shows that sandwich trading is a parasitic form of MEV, generating $212 million in revenue on Ethereum last year by executing front-running and back-running trades against unsuspecting DEX users. Atomic arbitrage is more lucrative as it has the effect of balancing prices in DEX pools, yielding 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.
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Source: Will Nuelle, Galaxy Ventures
CeFi-DeFi arbitrage is a more challenging strategy with no publicly available data to quantify the earnings of 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, accounting for only about 60% of the market share. This is based on simulations of CeFi quoted 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.
Moreover, 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 highly competitive, and (ii) accumulate more value for the base layer (Ethereum) in terms of fees. Meanwhile, the liquidation strategy, though with a gross profit margin of 51.1%, struggles to scale, making it less competitive (and less significant 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.
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Source: Will Nuelle, Galaxy Ventures
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Source: Will Nuelle, Galaxy Ventures
Stable Relationship Between MEV and Block Space Demand
The percentage of MEV as a proportion of transaction fees paid remains stable over time, neither increasing nor decreasing. As shown in the graph above, the percentage of MEV in block space hovers around 10% per week. 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 fluctuation is very reminiscent of a mean-reverting time series in financial markets. In fact, MEV activity may be closely related to volatility itself.
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Source: Will Nuelle, Galaxy Ventures
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Source: Will Nuelle, Galaxy Ventures
In other words, if transaction fee consumption in a week amounts to $100 million, we can predict that 90% of it is due to external demand for using applications, and 10% is internally generated due to risk-free profits from changes in the week’s state. If 30% is created by MEV and 70% by non-MEV, then it is reasonable to believe that the next week will likely return to normal. We will closely monitor this situation to see how it evolves over time.
It is worth noting that this stability of around 10% only applies to financial applications (DEX and lending protocols) on the blockchain. These applications generate MEV, not 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.
Summary: MEV Currently Plays a Minor Role, But Will Play an Important Role in the Future
While MEV has the ability to disrupt incentive protocols 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 events like the FTX or Silicon Valley bank black swan market, 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 acts as a demand multiplier, increasing external demand for using applications by 1.1-1.3 times.
Nevertheless, the impact of MEV on future block space consumption could 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. As a simple example:
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Source: Will Nuelle, Galaxy Ventures
The most profitable blockchains in the future are likely to be those that possess the following characteristics: (a) lower transaction fees to stimulate network activity demand, and (b) primarily utilize network activity in the form of validators/sorters/burn capturing MEV.
The existence of phenomena like MEV is just another reason for block space to become an unprecedented business model. Its unique characteristics make it a solid 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. While Ethereum’s net income profit margin fluctuates, since January 2023, its average net income profit margin has been 33.9%.
Easy to generate network effects. Generally, SaaS products lack network effects, while social media applications and markets have them. With more applications and capital joining, block space is improving, continuously driving up transaction fees with network effects. Network effects can generate additional income through MEV.
Block space scales over time. Some block spaces will benefit from scaling, such as L2, which have further growth potential.
MEV’s external demand multiplier effect. MEV is a feature that always exists in blockchain systems. While MEV may harm consensus, it contributes fees on a large scale to the ecosystem. For every $1 in transaction fees on Ethereum, approximately $0.10-$0.30 in MEV fees 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 profit margin business.
Strongly cyclical. Income from selling block space is highly cyclical. It depends on market conditions and is often closely related to market volatility.
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