In-depth exploration of the consensus capital market in the era of encryption

Original Authors: Saneel Sreeni, Leo Zhang

Translation by: Block unicorn

"Who controls the spice controls the universe." ------ Frank Herbert, Dune (film)

Introduction:

Commodities are the basic raw materials that form the foundation for the production of everyday goods and services. The history of commodities reflects civilization itself. Humanity has waged wars against each other to control the most important resources; from rice to metals, to spices, to oil. As more aspects of the global economy and daily activities migrate to the crypto economy, what will become the most sought-after commodity of the new era?

Block Space

All economic activities on public blockchains are built on block space. Consensus producers, such as miners and staking validators, provide block space, and each transaction requires block space. As on-chain activity increases, network fees rise, and as the value of block subsidies and fees increases, more people are incentivized to compete to add the next block to the blockchain.

Since block space is a commodity, it can serve as the basis for financial instruments—hedging production or enhancing returns. This financialization ultimately leads to a comprehensive capital market, similar to the way all important commodities have evolved throughout history.

In this article, we will delve into the historical context of commodity markets, the importance of decentralized consensus in the digital world, the economics of consensus production, and what a consensus-native capital market will look like.

Commodity Markets: A Historical Overview

As early as 4500 BC, the inhabitants of ancient Sumer used clay tokens and tablets to determine the dates for future goods delivery and settlement rules, essentially functioning as futures contracts. Nearly 3000 years later, a code of Hammurabi outlined the payment rules for farmers mortgaging their property. Farmers were not required to repay debts with the grain they produced but retained the right not to repay in the event of crop failure. These basic rules helped producers manage risk, thereby promoting more stable agricultural production.

These financial arrangements continued to evolve and standardize, with one of the earliest formal commodity exchanges being the Dojima Rice Exchange established in 1697. Merchants would trade "rice tickets," rather than actual rice, which represented the right to claim rice from their warehouses. Based on rice tickets, merchants developed many derivative contracts that are now commonly traded, such as short selling, forwards, and options.

More than a century later, the Chicago Mercantile Exchange was established and grew to become the global leader in the trading of futures and options for grains and agricultural products, with trading volumes far exceeding those of physical commodities.

These developments indicate that financial markets for commodities enable producers and consumers to better manage their risks, allowing them to effectively scale their operations.

Dojima Rice Exchange, Japan

As the commodity market gradually matured and became more complex, the types of financial instruments available to help manage associated risks also increased. Today, they cover almost all commodities, from sugar to coffee to gold and energy markets.

And because commodity production is influenced by various physical attributes, stable consumption and production of commodities are not a given; commodity production is always accompanied by a robust commodity market. Without these markets, the flow of commodities can easily become volatile.

The Metaverse Era

As more aspects of daily activities shift to digital, the value of related resources (such as data and computation) has skyrocketed. While the underlying technologies of the digital age are still in their infancy, the acceleration due to Moore's Law and the abstraction of software development is astonishing. For these reasons, phrases like "data is the new oil" have become relatively common.

As Dijkstra commented in 1972 (after surveying 1000 computer scientists), "I do not know of any other technology that can cover a ratio of 10¹⁰ or higher: computers, with their astonishing speed, seem to be the first environment that provides us with highly layered artifacts, possible and necessary." At this point, it is no longer useful to view the digital universe as a physical phenomenon. Instead, software is what Abelson (nuclear PhD from UC Berkeley) and Sussman (MIT computer science professor) refer to as "program epistemology." It has become an infinite medium for human expression.

This naturally raises the question—where will this path ultimately lead us? Many science fiction works depict different versions of the metaverse, but they all seem to be built on one baseline: a digital reality parallel to physical reality, filled with its own worlds, economies, and digital assets. Matthew Ball more specifically describes it as "a massive and interoperable real-time rendered 3D virtual world network that can be synchronously and continuously experienced by an infinite number of users, with a sense of personal presence and data continuity, such as identity, history, rights, objects, communication, and payments." Ball further mentions that crypto networks will span and drive several categories critical to realizing the Metaverse, primarily computation, interoperability tools and standards, and payments.

In reality, given enough time and technological advancement, distributed networks supported by crypto economic schemes will dominate everything: how metaverse data is stored, presented, and accessed, which is quite plausible. It may also guide the development of metaversal social structures; we have already seen how DeFi and crypto gaming encourage users to prefer user-owned protocols and share specific usage economic incentives rather than rent extraction.

As the paradigm shifts towards users owning stakes in the platforms they use, they are increasingly reluctant to cede control of their digital selves to a few centralized entities like Facebook and Microsoft (which is already happening). The metaverse is likely a necessity rather than a possibility, thus relying on crypto networks for widespread adoption and sustainable, user-centric growth. Therefore, block space will become the core commodity of the metaverse.

Block Space Commodity

We have built a vast market globally to ensure we have stable food and energy production to sustain the development of our society. So, what kind of market will emerge for the foundational commodity of the metaverse, block space?

Fundamentally, block space is a representative unit of shared computational layers and states across multiple users; blockchains exist as records of changes and additions to that state, and crypto networks serve as the market for the production and use of block space.

Users issuing transactions with additional fees indicate their need to purchase block space to alter the global state of the network, while participating consensus node operators (miners, validators, etc.) provide security to the network by producing block space composed of these state changes. While this sounds simple, the dynamics of the block space market are quite complex.

On one hand, block space has an implicit time value. In Ethereum block space—who gets what and why—we discuss why future block space is inherently less valuable than current block space.

As an artificial example, users attempting to deposit currency in an on-chain money market prefer to lock in current interest rates rather than potentially lower future rates. Similarly, users trying to purchase NFTs prefer to complete transactions before they are snatched up by others.

Historically, this time value has been quantified through network fees, and block producers default to including transactions based on the highest fees. This also means users are incentivized to pay higher fees for more urgent transactions, which can lead to phenomena such as miner extractable value (MEV).

Even attempts to add a global clock to the blockchain, such as Solana's proof of history, which uses serial hashing to timestamp transactions entering the network, still have implicit time value in their chains. Compared to fee-based models, sequence-based inclusion models are more affected by latency; those who wish for their transactions to be included in the clock network will optimize favorable network topologies and proximity to large node operators, both physically and digitally, to ensure their transactions are prioritized.

This is akin to the principle of competing for proximity to exchanges in traditional high-frequency trading.

Similarly, for suppliers (consensus node operators), the now-monetized block space is more valuable than future block space.

The profit calculation for consensus producers is the difference between consensus incentives and node operating costs. The rewards received by node operators can be highly volatile: spot prices, transaction fees, and the probability of discovering blocks are all factors contributing to reward uncertainty. Different networks have different incentive mechanisms to pay node operators, further complicating matters.

The costs of running a node can also vary significantly, as different networks often have vastly different requirements for participation as validators. Proof-of-work networks are driven by the mining hardware market, cheap and reliable electricity, etc. In contrast, the considerations for running a Proof-of-Stake (PoS) ETH2.0 node depend on minimal power consumption and the capital required for staking.

We can further break down the supply side into operating expenses and capital expenditure costs. For networks that require higher levels of computation at the base layer, capital expenditures tend to be high.

In addition to Bitcoin and Ethereum mining, other examples include Arweave and Filecoin, where validators expand storage capacity and RAM for fast processing, Solana proof of history nodes that have high computational requirements due to serial hashing, and any zero-knowledge. GPUs and other processing units capable of rapid linear calculations can significantly accelerate the speed of proof computations.

However, it is important to note that, considering factors like state bloat, each network's nodes will incur some capital expenditures that may ultimately recur in nature. Capital expenditures can be high and typically amortize over time.

As for operating expenses, miners incur operating expenses in the form of electricity and maintenance costs. Staking validators incur OpEx in the form of staking requirements and tokens. For other consensus algorithms, OpEx costs lie between token-intensive and physically resource-intensive.

Almost every consensus algorithm views the right to produce blocks as a probability function weighted by the operator's validation capacity relative to the global validation capacity. This means that operators must increase their stake in the network's "validation capacity" accordingly to maintain a certain probability of block production.

For example, if other validators suddenly decide to stake an additional 5,000 ATOM to maintain a 10% block production probability, an ATOM validator with 1,000 ATOM will need to purchase an additional 500 ATOM if the total staked ATOM in the network is 10,000. The same applies to other popular PoS networks, such as Terra, Avalanche, and Near. The actual mechanisms may have subtle differences (i.e., Avalanche's cap on the total possible amount delegated to nodes differs from other networks).

This volatility can lead to additional fluctuations in validator rewards and may result in unforeseen operating expense costs, thus some network incentives favor accelerating the competition for dominant shares of network stakes (beyond the capacity for majority attack networks), such as in Solana's distributed inflation system:

As the scale of network utility grows, the healthy growth of node operators increases the network's security budget, enabling it to withstand attacks that disrupt consensus. Ideally, the costs of running nodes should be offset by the income generated from consensus. However, as we explained in The Alchemy of Hashpower, consensus producers experience four prototype market phases, some of which may lead to producer bankruptcies.

The structural nature of block space production and consumption indicates a strong need for isolating potential risks in the block space commodity market. We refer to these as consensus capital markets.

Consensus Capital Markets

The original financial instruments for block space already exist today; hash rate indices, gas tokens, and staking derivatives are various attempts to establish consensus capital markets. However, hash rate indices/futures and gas tokens have failed to achieve significant liquidity, and these markets are often opaque and cumbersome for buyers and sellers.

In other cases, demand has never materialized because the difficulties in pricing assets like gas tokens have muddied the liquidity supply on-chain and on centralized exchanges.

Staking derivatives have achieved great success in freeing stakers' principles to participate in other activities, but they have not provided a complete solution for the needs of block space producers.

ETH sent to ETH 2.0 staking contract

Without a complete hedging solution, validators face risks from network assets (due to their stakes) and volatility risk related to block space demand (fees). Through staking derivatives, validators on PoS networks will sell token representations of their staked assets in exchange for any asset they wish to price (i.e., PoS validators will sell their staked ETH for stablecoins) to hedge against fee-related risks.

The value of staked assets equals the underlying network assets plus the expected accrual of future network fees, and holding staked assets means facing the volatility of validating future cash flows. Selling assets at market prices "locks in" the fixed price of these future cash flows (represented by the price difference between staked assets and underlying assets).

Since validators need to trade with the market to perform this hedging, they trigger significant price risks because when they want to re-engage with network activity or unlock their stakes, they need to purchase staked assets at market prices.

Given that staked assets typically trade closely at parity with underlying assets, validators ultimately cannot fully hedge their risks due to Delta (hedging value) risk exposure. Cost-conscious validators need additional tools, as they wish to minimize risks without needing to become active traders, especially in turbulent markets.

Ideally, when building hedges for block space production, it should meet the following two attributes:

1. Isolate network activity risk (fees quantified by network demand for block space).

2. Isolate network asset price risk (a function of external markets).

These two requirements are met in exchange-based arrangements.

Below is a high-level diagram constructed by Alkimiya. It reflects the energy exchanges found in traditional commodity markets: the buyer pays fixed stablecoin payments to the producer (in this case, miners/network validators) during the contract period, while the producer pays all rewards based on a certain metric during the same time period (specific to the consensus algorithm).

During this period, the contract buyer receives potential block space demand in the form of network fees and block subsidies, while the validator isolates themselves from network activity and asset price risks.

We broadly categorize indices as units of validation capacity per unit index time. The most commonly discussed index in proof-of-work mining is hashes per second. For Ethereum 2.0 Proof-of-Stake, this may look like ETH staked per epoch (the time period during which selected validators can propose blocks).

This index is particularly important for validating whether validators deliver their promised share of rewards. Our design allows validators to list contracts promising any index to reach their maximum available resources, i.e., a miner with 10 Th/s on Ethereum can list contracts promising reward indices of up to 10 TH/s (10 trillion computations) as long as the total of all indices across all their contracts equals this amount.

For example, if the same ETH miner sells a reward worth 1 Th/s for a 15-day contract while the global hash rate remains around 1,000 Th/s during that period, we expect the validator to provide about 0.1% of the block rewards for that time period (before considering factors like randomness, mining pool fees, contract trading fees, etc.).

Another important component of these contracts is the fixed payment made for the contracts, with any potential factors (time, network asset prices, global validation capacity, etc.) corresponding to the fluctuations in block production value, thus corresponding to the fixed value of any swap contracts paid at the time of contract creation. Pricing these swap contracts is a complex topic, and we will explore pricing models in more depth in future articles.

Further Applications

We contextualize the demand for consensus capital markets by hedging the production costs of suppliers. However, a strong market would not exist without considering the demand from buyers. While the demand for the original form of block space is very clear, the demand for the aforementioned exchange-based structure may seem less obvious. However, the use of these swaps has significant prospects beyond simple speculation.

On one hand, swaps provide an interesting new primitive that can be integrated into more complex DeFi structures. With the success of platforms like Ribbon Finance and Friktion Labs, it is clear that there is a strong demand for simple, intuitive financial products that allow end users to automatically and permanently access a range of different financial strategies, such as covered calls. So far, these strategies or structured products have not enabled users to directly access the value of block space.

As a concrete example, during token airdrops, NFT minting, or days of high market volatility and widespread on-chain activity, the value of block space often rises significantly. Investing in block space through swap-integrated products allows buyers to make targeted bets on event-driven network congestion and profit from these anticipated events.

In general, another exciting application of these swaps is the opportunity for fee stabilization. For multiple platforms and services integrated with crypto networks, such as Coinbase or similar exchanges, end users often have to pay network fees on top of platform fees when interacting with the blockchain using the said platform.

For many services, this can impair user experience and render the platform unusable at times. Conversely, if these services know how much block space they average occupy, they can purchase swaps equivalent to the percentage of that validation capacity at a fixed price.

The service still pays network fees associated with the relevant transactions, but because they have effective swap contracts, they will ultimately redirect these network fees to their own fixed payments, and then they can simply quote a fixed fee to end users to cover the payments they make for the swap. For example, if Coinbase knows it has been averaging 1% of block space on Ethereum, it can purchase a swap equivalent to 1% of the global hash rate.

Coinbase still pays gas fees associated with its transactions, but it expects that 1% of network rewards (including these fees plus some margin from block subsidies) will be returned to it, which should cover the cost of purchasing 1% of block space. End users only pay the fixed fee for purchasing the swap.

Conclusion

As the use of crypto networks—and the expanding demand for block space—becomes increasingly common, the appeal of participating in incentive programs to become block space producers through consensus will grow. This means that a healthy and robust market to hedge block space production will almost certainly be needed, and thus consensus capital markets will become as ubiquitous as the networks they are built upon.

By creating more reliable income guarantees for block space producers and pathways to hedge the inherent volatility of block space production, consensus capital markets are expected to lower the barriers to entry for becoming network validators, contributing to the ongoing decentralization of these domains in the long run.

Each network has different economic considerations, and what we present here is a general framework for consensus swaps; Alkimiya is committed to developing these products across various networks and generating cash flow on top of them. We have also previously published documents and research on what consensus swaps for proof-of-work mining look like at Alkimiya.

In future research and releases, we will delve into specific network structures, including but not limited to standard proof-of-stake (ETH 2.0, Cosmos), storage, ZK validation, Solana, and more.