Zee Prime Capital: Analysis of Layer 2 (3, 4) from the perspective of blockchain space economics
Original article by @mattigags, Zee Prime Capital
Original translation: Heilsman, ChainCatcher
Talking about Blockspace
This article took nearly a year to write. Market conditions have changed dramatically since the first draft, but the basic theme and thesis have been developed. After a period of discussion, we decided to revise and continue with publication.
This article will discuss:
What is Blockspace?
Why is it important?
Blockspace as a Veblen Good vs. Blockspace as a Giffen Good
The Jevons Paradox of Blockspace
The future of block space allocation
What is Blockspace?
Blockchains are also called state machines. In computer science, state refers to the memory capacity of software. Today, the Internet is largely based on private and closed state retention. Behind the walls of websites and applications, our collective memory is controlled by gatekeepers.
Humans and machines are constantly generating free-flowing information, which is huge and fills the entire Internet. Therefore, the credibility and truth of information have become scarce. Blockchain can outsource our shared storage data to machines.
Truth becomes a question of block finality, because blockspace is our time capsule. These memories are highly specific and limited in their expression. They are uploaded into our “collective memory” based on the willingness of market participants to pay.
Dennis Nazarov describes Web2 like this:
“The business model of Internet services is based on monetizing state. State is a competitive advantage that needs to be defended by keeping services proprietary and closed.”
Blockchains are effectively removing the monopoly that applications have on state retention. Since the amount of updates a blockchain can store at a given time is limited, state machines auction off their storage capacity. This storage capacity is determined by block space.
Rob Habermeier believes that block space is a key element for emerging applications:
“An ever-increasing number of applications rely on decentralized systems for payments, consensus, or settlement. As such, the application layer is the primary consumer of block space. Like any business, applications and their developers should be concerned about the quality and availability of goods in their supply chain.”
Blockspace as Fuel
Blockspace can only become a reliable and trustworthy coordination resource if it is organically scarce, or at least instills some sense of urgency to drive market forces to acquire this resource.
Just like the invention of refining crude oil into petroleum, the invention of shared state-keeping/blockchains refines time into the standard fuel of block space. Time is our crude oil, blockchains are refineries, and applications are gas stations. All of these power the new information highway for value transfer.
Technology is the foundation on which society depends. As technology develops, society changes. The future Internet will run on blockchain space, powering application services coordinated by state machines.
Mechanical clocks helped power the industrial revolution by providing universal coordination of “9-to-5.” Blockspace can help power the next information revolution by providing universal coordination of value transfer. We are breaking time down into block times and “outsourcing” billing, thereby expanding markets to places that centralized bookkeeping could not reach before.
Hayek defined the market as a machine that records change and a price system that facilitates the coordination of social resources and knowledge. Blockspace is an extension of the market because it is an invention that facilitates resource coordination. It bundles trust with state, allowing us to compute/verify information without considering it.
Blockspace as a Veblen Good
Some revolutionary inventions started out as luxury goods. Let’s take the invention of timekeeping: Mechanical clocks in the 14th century were expensive to produce and maintain, making them accessible only to the wealthy. Only a few centuries later, pendulum clocks made timekeeping more scalable and widespread.
Early cars were owned by the wealthy. Electricity became a social trend. It took only a few decades for electrification to transform everything from luxury to commonality.
Today’s blockspace, although open to all on-chain users, still has attributes similar to luxury goods. Especially during the peak of gas usage on Ethereum, using blockspace is almost a status symbol. Is today’s blockspace a “Veblen good”?
Investopedia summarizes Veblen commodities as follows:
Veblen goods are goods whose demand increases as their price rises;
Veblen goods are usually well-made, exclusive, high-quality items that are a symbol of status;
Veblen goods are often sought after by affluent consumers who value the usefulness of the goods;
The demand curve for Veblen goods is upward sloping.
The demand for Ethereum blockspace can be seen as conspicuous consumption, and of course it sometimes determines economic returns. Blockspace is a casino for innovators, while the market is still searching for new, high-utility products with product-market fit.
In the Ethereum ecosystem, the price of applications slowly being taken away by other blockchains or Rollups has finally reignited interest in application chains, i.e. applications that run their own state machines. Although it may be cheaper elsewhere, there is still expensive and valuable activity on Ethereum. Composable high-yield products such as Ethena, Pendle, Gearbox, and their capped vaults consolidate Ethereum's block space like a "Veblen good".
For example, the reason why those blue-chip NFTs are expensive is inseparable from the blessing of the Gas peak at the time of minting. Therefore, through the endowment effect and the initially expensive reflective nature, these NFTs become the main body of the flywheel, that is, more and more valuable.
Whether it’s the memecoin craze of 2024 or the NFT craze of 2021, the increased demand for “gambling” has made blockspace more attractive around the world. Given the high cost of each ETH “lottery ticket” and the wealth effect of SOL’s rapid appreciation, Solana has become the memecoin “Schelling point”.
Blockspace as a Giffen Good
Not all blockspace is created equal. It’s a class thing. Not everyone can afford the caviar of Ethereum. Some have to choose rice and potatoes because they are cheaper blockchains.
For non-salient block spaces, their properties may be similar to "Giffen goods". "Giffen goods" are considered necessities and non-luxury goods, but they are theoretically similar to "Veblen goods" in that they have an upward sloping demand curve, that is, demand increases as price increases.
The theoretical existence of such a good is expected by the lack of substitutes and income pressure. A good example of a "Giffen good" is the rise in potato prices during the Irish famine of 1845, but the quantity of potatoes demanded increased. Higher quality substitutes such as caviar or meat are so out of reach that even these non-luxury goods become in high demand.
“Because Giffen goods are indispensable, consumers are willing to pay more for them, but this also constrains disposable income, making the purchase of slightly higher-priced goods more out of reach. As a result, consumers buy even more Giffen goods.”
Therefore, Ethereum's blockspace has similarities to other blockspaces. If one wants to participate in the Meme economy, blockspace is an essential and urgently needed commodity. But ETH blockspace is a very expensive "lottery ticket", and increasing blockspace has become particularly prominent and in high demand during the 2021 cryptocurrency bubble, continuing to attract capital bets. As the cryptocurrency market ushered in a new bull run in 2024, more economic activity occurred outside of Ethereum.
Will new blockspace continue to resemble the properties of a Giffen good? Are new market participants priced out of Ethereum’s blockspace? What does this mean for the future of blockspace pricing?
I believe that as a wider range of product markets suitable for blockchain emerge, blockchain-related economic activities will gradually exhibit the characteristics of Veblen Giffen goods , that is, the demand for blockchain increases as its price rises.
The Jevons Paradox of Blockspace
The Jevons Paradox is an economic paradox where optimizing energy consumption leads to more energy consumption. In the 19th century, William Stanley Jevons observed that more efficient steam engines led to higher coal consumption. So, will we run out of block space at some point?
As more efficient blockspaces become available, the demand for them will likely increase, especially as more and more innovative applications fill the blockspace with information, just like widening a road doesn’t stop traffic jams.
Blockspace will not be fully commoditized because there will be different qualities or states of blockspace. For example, if traffic congestion is worse in high-density areas with more commuting populations, we will encounter hubs with more expensive blockspace.
Adding more block space is simple, but it is essentially like building a highway in the desert. Who wants to drive through the desert every day? So, it is not only a matter of adding more block space, but also a matter of allocating high-demand blocks efficiently.
Schedulable > Scalable
The global supply of blockspace is increasing. When the crypto industry goes through a period of activity (usually followed by mass media coverage), we are likely to see a surge in global demand for blockspace.
During periods of heavy load, demand for both high-state (and quality) blockspace and cheap blockspace surges. More sophisticated market participants require blockspace delivery guarantees. As the economic value of certain transactions continues to increase, the dispatchability of high-state blockspace will become far more important than the availability of any blockspace.
This is why blockspace will likely never become a pure commodity. Any useful future use case for blockchain will involve a financial element (distributed consensus is not free), so savvy actors will pay for transaction assurance. Citadel traders and Robinhood users play different games, and the rich use different banks than the middle class. Blockchain participants are no different.
Efficiency in block space allocation was emphasized, with the goal to “…maximize the amount of block space available and ensure it is always allocated to the state machines that need it most: constant generation and allocation provides global consensus resources to those who need it most. Nothing is wasted.”
Today, we are stuck in an inadequate equilibrium of L2(3, 4) frenzy — each new Rollup adds more blockspace. While this may be profitable in the short term (for investors and founders), a long tail of isolated blockspace with extremely volatile demand is not a sustainable way to produce and distribute blockspace at scale.
The reason is that applications need a more comprehensive and stable large-scale execution environment. The current block space market is fragmented and unpredictable. The "add more block space" expansion mentality is like adding more bridges between crowded intersections without considering building traffic lights and highway ramps.
This problem will likely eventually be solved through market-based solutions. Blockspace as a primitive tool has expanded the market to many new use cases, but lacks the market itself. Until blockspace has proper markets (both for delivery and to allow hedging), its full potential may not be realized.
We’ve seen examples of this in the past. In the 1970s, hedge fund investor Ray Dalio helped McDonald’s achieve cost stability and new product offerings by hedging input costs for chicken nuggets through futures (a relatively new invention at the time). Until now, the cost of chicken nuggets has been too variable to be a viable product.
Blocks themselves need markets, they may need true gas cost markets or something similar. Perhaps the answer is not synthetic futures as in the example above, but we expect a more sophisticated approach to allocating block space will emerge in the future.
As demand for block space increases, so too will the need for specific execution guarantees and global blockchain allocation (rather than local chains). In the future of the Jevons Paradox, we may exist in a paradigm that goes beyond layers when it comes to block space allocation. The existing blockchain obsession is just a symptom of the early stages.
Given the path dependencies of cryptocurrencies, the dynamic nature of design constraints, and unpredictable computational pricing, it is difficult to understand the end game. Whether it is ideas around blockspace/gas exchange, chain abstraction, or the (Polkadot) core time model, these represent initial ideas beyond layered design.
What really matters is block space and actually having user applications. Everything in between is investor-sponsored entertainment that will be abstracted away over time. This is the narrative of how the industry went from entropy of value extraction to negentropy of value generation through application dominance.
Thanks to Ankit, Hasu, Rob, Luffi and long_solitude for their comments and feedback.
Along these lines, we have a firm investment in Lastic — a modular blockspace marketplace, an undisclosed chain abstraction project, have supported Biconomy since 2020, and hold DOT.
