Is the key to the future development of Ethereum the blob fees?

Author: Michael Nadeau, The DeFi Report; Translated by: Tao Zhu, Golden Finance

A few weeks ago, Standard Chartered Bank released a report, lowering its year-end price target for ETH from $10,000 to $4,000, which became headline news. The report pointed out that the L2 roadmap is a major catalyst for Ethereum's struggles, claiming that L2 is "stealing Ethereum's GDP." The conclusion is that Ethereum's future value needs to be adjusted accordingly.

We will conduct our own analysis on this topic and share our findings with you.

But before this, we believe it is wise to analyze Ethereum's economic trends from scratch. This will lay the foundation for future analysis and clarify the necessity of Ethereum's development and expansion of "blobs" (i.e., Ethereum's data availability network).

This is the focus of this week.

As the situation develops, we will update our views on the market. Currently, we are looking for bottom/structural change signals and holding cash.

Real Economic Value (REV) of Ethereum

defines real economic activities (REV)

REV = Value derived from user activity, directly attributed to Ethereum service providers and ETH holders. It does not include token incentives or fees paid to block builders (which we will discuss later in the report).

Four main components:

1. Base Fee: This is the minimum amount of ETH that users must pay to process transactions on Ethereum L1. The base fee is dynamically adjusted based on network congestion to reach a specific block utilization level (50%). In terms of value accumulation, the base fee is "burned," meaning it is deducted from the circulating ETH. Within the scope of offsetting ETH issuance, the "burned ETH" can lead to a deflation of ETH supply, bringing value accumulation to ETH holders — similar to stock buybacks in traditional companies.

Basic Fees: Key Points

• In the past 90 days, the base fees of Ethereum accounted for 50% of the total actual economic value generated by Ethereum validators.
• A total of 48,007 ETH have been destroyed and removed from circulation (calculated as 94 million USD at the current ETH price). Of this, 3.7% comes from L2, with Base leading. This offsets the issuance of 239,492 ETH during the same period (token incentives paid to validators), resulting in an annualized inflation rate of 0.6% over the past 90 days.
• When we zoom in below, we can see the destruction of Ethereum's base fees over the past four years. In March, the average base fee for Ethereum was only 102.7 ETH/day. For reference, this is less than 1% of the network transaction volume in November 2021 (with a base fee of 11,809 ETH/day), and only 8% of the lowest point of Ethereum's base fee during the bear market in 2022.
• The decrease in base fees highlights the impact of EIP4844 — a technical upgrade that allows for cheaper L2 transactions, implemented in March of last year. This is a key decision made by the Ethereum Foundation to expand Ethereum through the "L2 roadmap," which led Standard Chartered to lower its price target for ETH. We will provide more insights on this in future analyses.

2.Priority Fees: Priority fees are paid by Ethereum users, exceeding the base fee, to ensure time-sensitive transactions (such as arbitrage, sandwich attacks, liquidations) are moved from Ethereum's mempool into confirmed blocks. These fees are attributed to Ethereum validators (shared with passive stakers of ETH). In the past 90 days, Ethereum validators have earned 25,169 ETH in priority fees (equivalent to 46.7 million USD at current prices). This accounts for 26% of the validators' REV.

Priority Fees: Key Points

• Although Ethereum's priority fees are at their lowest level in 4 years, we can see that the extent of the decline is not as severe as that of the base fees. Why? Priority fees only apply to L1 transactions, while a large portion of Ethereum's base fees has shifted to L2 over the past year. In March, the network's priority fees averaged 218 ETH/day—down 88% from the peak at the end of 21. Compared to the lows of the bear market in 22, priority fees are currently down 55%.
• As more and more Ethereum execution activity shifts to L2 (such as Base), we should expect the priority fees on Ethereum L1 to continue to decline.

3. Blob Fees: "Blob Fees" are fees paid by L2 to Ethereum for data availability. These are the new fees introduced by EIP4844. Similar to the base fee, the blob fee is "burned" and removed from circulation.

Blob submission fee: Key points

• Over the past 90 days, L2s in the ecosystem have paid 1,605 ETH ($3.5 million) to Ethereum L1 (2% of the total REV). Base accounts for 39% of these fees, followed by Taiko (18%), Worldchain (15%), Arbitrum (14%), and OP (4%). Overall, the top five L2s currently account for about 80% of blob commit fees.
• Given that Ethereum intends to scale through L2, we believe it is reasonable to predict that the vast majority (over 95%) of transaction executions will occur on L2 in the future. Therefore, as L2 expands, blob submission fees (for data availability) should account for the vast majority of what Ethereum L1 validators pay.
• If Ethereum were to replace its current REV solely through the current DA fees, it would require 1.4 billion transactions per day from L2 (16,303 transactions per second). Currently, this is 92 times the total daily transaction volume for L2. That said, blob fee pricing is dynamic, and thus fees will increase in a non-linear manner with demand (similar to L1 fees).
• We performed some analysis using the Blob simulator assembled by Tim Robinson. The results are somewhat concerning. Why? L2 transactions per second only increasing by 2.5 times would lead to congestion on Ethereum L1. In this case, L2 fees would soar to $0.40. This is not a good thing. That said, protocol updates for blob targets (Pectra, PeerDAS expected in mid-25) are coming soon. If L2 expands by 2.5 times, the target blob/block needs to be doubled (planned for May 7 via Pectra upgrade) in order to bring the cost/transaction down to $0.01. That said, we will see how the speed of future upgrades supports further expansion at the L2 level.

Basically, there are 3-4 L2s continuously meeting the target blob/block (3). This accounts for about 70% of the blob space demand. Therefore, this means that other L2s need to compete for blob space, which in turn raises fees. This is basically the same scalability issue that Ethereum encounters at the L1 level.

We expect Ethereum to expand its blob size and target blob/block through protocol updates (such as PeerDAS, Fasaka upgrades, etc.). But this is not an easy task. It takes time. And Ethereum doesn’t have much time left.

How long will L2 endure scalability barriers before seeking alternatives?

4. MEV: MEV is paid by users (bots) often referred to as "searchers". Basically, you have bots trained to find arbitrage opportunities between DEXs/CEXs, liquidations, and the opportunity to "sandwich" other users in Ethereum's "Mempool" (a pool where transactions pass through before being packaged into blocks for validators). When they decide which transaction to make (based on the mempool), they submit it to the "block builder" – paying a priority fee + an additional "tip". These fees (paid by users/bots) are collected by block builders, who then use these funds to bribe validators to validate blocks. Block builders keep about 30% (these are "off-protocol" fees, which we'll discuss later in the report), and validators take about 60% of the MEV (shared with stakers via MEV boost). Searcher bots keep about 10% of the MEV generated by the transactions they submit.

MEV: Key Points

• In the past 90 days, Ethereum validators have received 21,159 ETH ($39 million) in MEV Tips (accounting for 22% of the total REV). Similarly, these fees are paid to block builders (who are funded by bots/"searchers" that require time-sensitive transactions).
• We analyzed the "searcher" trading activity over the past 30 days to determine which trades drove the most MEV. Here are our findings:
• Arbitrage trading volume: 3.6 billion USD (searcher profit 1.9 million USD)
• Sandwich Trading Volume: $6.3 billion (Searcher Profit $135,000)
• Settlement trading volume: 86.4 million USD (Searcher profit 176,000 USD)

Generally, seekers will retain about 10% of the value extracted from the MEV created from their trades. Builders will retain about 30%, while validators (and passive stakers) will receive about 60%.

• At the end of 2021, during the peak of on-chain activity, validators earned about 1,619 ETH daily from MEV. In the past 90 days, this number has dropped to 230 ETH per day (a decrease of 86%).
• From the chart, we can see that MEV rewards are inconsistent and can surge significantly during congested/time-sensitive transactions. The most profitable MEV day for validators occurred on May 3, 2023 (earning 11,228 ETH in MEV). This is related to the launch of the Pepe memecoin.
• MEV is only applicable to transactions conducted at the L1 level. Therefore, as trading activity shifts to L2, we should continue to see a decrease in the MEV earned by Ethereum validators.

Token Incentives

As mentioned in the introduction, the actual economic value only includes the value paid to Ethereum validators through user transactions (shared with ETH stakers).

But this is not the only way for validators to earn rewards.

Finally, there are token incentives/network issuance. This is the ETH paid as a consensus reward to Ethereum validators to protect the network.

We can see below that when Ethereum transitioned from proof of work to proof of stake through the merge, the token incentives decreased by about 80%.

Token incentives are used for the initial bootstrap of the set of decentralized validators in the blockchain network. But over time, we should see them go down, and user fees will compensate for the security of the supply side.

This is what we have seen in the history of Ethereum, but now we can observe that due to the reduction in user fees associated with EIP4844, token incentives are rising again.

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Data: Token Terminal, Decentralized Finance report

Token Incentives: Key Points

Over the past 90 days, Ethereum has paid validators an average of 2,631 ETH ($4.7 million) per day in newly issued tokens.

During the same period, Ethereum validators earned 515 ETH/day ($926,000) from MEV and priority fees.

This means that currently only 16% of Ethereum validators' income comes from user activity. The rest comes from token incentives/network issuance.

Validator Yield Rate

The four components of REV + the token incentives of Ethereum constitute the dynamic yield of Ethereum, which will also fluctuate based on the amount of ETH staked on the network (currently 34.3 million ETH, accounting for 28% of the supply).

Finally, we can visually see the relationship between the income of validators, which is the new ETH issuance and REV (priority fee and MEV) below. Over the past 90 days, the network has issued 239,000 ETH to validators, and they have also earned 46,000 ETH from priority fees and MEV (which accounts for about 16% of the total value received).

Off-Protocol Income (Block Builders)

In addition to the value obtained by Ethereum validators (and passive stakers) from user transactions, Ethereum also has "hidden" value from user transactions, which is paid directly to block builders.

Workflow:

User Submits Transactions — > Ethereum Mempool — Identifying Value > "Searchers" (Bots) (Arbitrage, Mezzanine Trading, Liquidation) —> Submitting Additional Transactions to Block Builders (with Tips) — > Block Builder Bundle Transactions — > Submitting to Validators (with Tips) — > Validators approve transactions and keep most of the tips (block builders and searchers keep a portion of them).

The portion retained by block builders and searchers is considered "off-protocol" revenue, as it is not shared with validators and passive ETH stakers.

Block Builders: Key Points

• Currently, 90-95% of Ethereum blocks are built by "block builders" using protocols such as MEV-Boost. This outsources block-building functions to validators (reducing complexity) while allowing them to earn MEV (shared with stakers).
• In the past 90 days, block builders have earned 12,524 ETH. This accounts for approximately 30% of the total MEV during this period.
• Over the same period, approximately 20% of block builder revenue was returned to users (2,550 ETH) through "rebates". A "rebate" is generated when a user allows their transaction to be "rolled back" – meaning that the "searcher" submits the transaction after the user's transaction (without affecting the user's transaction), but still generates more profit for the "searcher" transaction. Users can qualify their transactions for rebates using protocols such as Cowswap, which utilize private RPCs to share a portion of the transaction details in the mempool.
• In the past 30 days, 3 block builders were responsible for constructing 87% of the Ethereum blocks. They are BeaverBuild, Titan Build, and Rsynch Builder.

If you're curious, here is an example of an Ethereum arbitrage trade where 21 tokens are exchanged across 49 trading venues, ultimately yielding a profit of $108,881.

• Searcher Address: 0x346C802df3404BEC2f265603db28B815321251Ee
• Contract Address: 0xe6b1DE575e7e610889ea21024834e120f92033a3 (handling arbitrage + paying builder fees)
• Builder: Titan Builder

Below, we can see one of the payments made to the Titan block builder from the contract address on Etherscan:

I hope this article can lay a solid foundation for our further analysis to assess the feasibility of the Ethereum roadmap and the value accumulation brought to ETH through "blobs."

This work has produced some key observations and questions:

• Ethereum has disrupted itself through the L2 roadmap. It now needs to rebuild its economy in a more B2B model (L2 as clients) rather than a B2C model (individual users as clients).
• As users continue to shift to L2 for better execution, the base fees, priority fees, and MEV on Ethereum should continue to decrease.
• These fees will need to be replaced by "blob fees," which are data availability fees. We believe this will require large-scale, substantial L2 upgrades and a MOAT for Ethereum DA.
• We believe that the majority of execution activities on Ethereum will shift to L2. This may not be realistic, as L1 may always retain a portion of users. How large this group is and what use cases will remain on L1 is still unclear to us today.
• In order for the roadmap to be effective, we believe that L2 needs to experience a surge at the scale of the website. Additionally, Ethereum needs to establish a moat in terms of data availability. This may manifest in the form of "block fees", but it may take a long time to achieve.
• Given that currently only three block builders are responsible for constructing about 85% of Ethereum blocks, we believe that concerns about centralization and censorship are reasonable.
• As institutions seek to tokenize stocks in the coming years, will they allow MEV to be leaked to Ethereum validators? Will regulators allow "sandwich" attacks to persist? For this reason, we believe institutions will seek to launch L2, where they can capture transaction fees + MEV. This could be a good thing for Ethereum, but it also requires scale. The good news is that the demand is there. For reference, all TradFi processes about 100 to 200 billion transactions daily in the stock and derivatives markets, payments, and other financial instruments.
• The fee loss of Ethereum L1 during this period has flowed to L2, which is the reason why Standard Chartered downgraded its price target for Ethereum. Meanwhile, L2 is also being adopted.

What will this chart look like when every bank and fintech company has stablecoins and stocks are tokenized?

As Charlie Munger (RIP) liked to say, "Show me the incentive, and I will show you the outcome." Given that TradFi companies will be able to control execution and MEV by building on L2, we believe they may be incentivized to build on Ethereum rather than Solana. The key question is whether Ethereum can scale the "blob" quickly enough to serve them.

In summary, we believe that the future of Ethereum entirely depends on "blob fees" (data availability) and its ability to generate network effects between L2s. Our future work in this area will focus on predicting the scalability of "blobs" and the value accumulation of ETH through dynamic pricing mechanisms and scenario analysis.