Zee Prime Capital: Examining Layer 2 (3, 4) from the Perspective of Blockchain Space Economics

Original Title: Beyond Layers

Original Author: @mattigags, Zee Prime Capital

Compiled by: Hailsman, ChainCatcher

A Discussion on Blockspace

This article has been in the works for nearly a year. Since the first draft, the market conditions have changed dramatically, but the fundamental themes and arguments have unfolded. 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" regarding blockspace
• The future of blockspace allocation

What is Blockspace?

Blockchain is also known as state machines. In computer science, state refers to the memory capability of software. Today, the internet is primarily based on private domains and closed state retention. Behind the walls of websites and applications, our collective memory is controlled by gatekeepers.

Humans and machines are constantly generating freely flowing information, which is vast and permeates the entire internet. Therefore, the credibility and truth of information 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 have high specificity and limitations in expression. Based on the willingness to pay of market participants, they are uploaded to our "collective memory."

Dennis Nazarov describes Web2 as follows:

"The business model of internet services is based on monetizing state. State is a competitive advantage that needs to be defended by maintaining the proprietary and closed nature of the service."

Blockchain is effectively breaking the monopoly of applications on state retention. Since the amount of updates that can be stored on the blockchain at a specific time is limited, state machines will auction their storage capacity. This storage capacity is determined by blockspace.

Rob Habermeier believes that blockspace is a key element for emergent applications:

"Emergent applications rely on decentralized systems for payment, consensus, or settlement. Therefore, the application layer is the primary consumer of blockspace. Like any business, applications and their developers should focus on the quality and availability of goods in their supply chain."

Blockspace as Fuel

Blockspace can only become a reliable and credible coordinating resource in the case of organic scarcity. Or at least instilling some "urgency" can prompt the market to exert its power to acquire this resource.

Just like the invention of refining crude oil into petroleum, the invention of shared state-keeping/blockchain refines time into the standard fuel of blockspace. Time is our crude oil, blockchain is the refinery, and applications are the gas stations. All of this powers the new information highway for value transfer.

Technology is the foundation on which society relies. As technology evolves, society also changes. The future internet will run on blockspace, powering applications coordinated by state machines.

Mechanical clocks helped propel the industrial revolution by providing universal coordination of "nine to five." Blockspace can help drive the next information revolution by providing universal coordination for value transfer. We are refining time into block time, outsourcing bills, thus expanding the market to places where traditional centralized accounting cannot reach.

Hayek defined the market as a machine for recording changes 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 the information itself.

Blockspace as a Veblen Good

Some revolutionary inventions start as luxury goods. Take the invention of timekeeping as an example: the production and maintenance costs of mechanical clocks in the 14th century were high, and only the wealthy could afford them. Just a few centuries later, pendulum clocks made timekeeping more scalable and widespread.

Early automobiles were proprietary to the wealthy. Being able to use electricity became a social fashion. The electrification transition from luxury to ubiquity took just a few decades.

Today's blockspace, although open to all on-chain users, still possesses luxury-like attributes. Especially during gas spikes on Ethereum, using blockspace is almost a status symbol. Is today's blockspace a "Veblen Good"?

• Investment Encyclopedia summarizes Veblen Goods as follows:
• Veblen Goods are those for which demand increases as prices rise;
• Veblen Goods are typically well-crafted, exclusive high-quality goods that symbolize status;
• Veblen Goods are often sought after by affluent consumers who value the utility of the goods;
• The demand curve for Veblen Goods is upward sloping.

The demand for Ethereum blockspace can be seen as conspicuous consumption, which sometimes also determines economic returns. Blockspace is a casino for innovators, while the market continues to seek new, highly practical, product-market-fit products.

In the Ethereum ecosystem, the pricing of applications is slowly being replaced by other blockchains or Rollups, reigniting interest in application chains, which are applications running their own state machines. Although other places may be cheaper, there still exist expensive and valuable activities on Ethereum. Composable high-yield products like Ethena, Pendle, and Gearbox, along with their capped vaults, solidify Ethereum's blockspace, much like "Veblen Goods."

For example, the high prices of blue-chip NFTs are also closely related to the gas peaks during minting. Thus, through the endowment effect and the initially high reflective nature, these NFTs become the main body of the flywheel, becoming increasingly valuable.

Whether it's the memecoin craze of 2024 or the NFT craze of 2021, the increase in "gambling" demand has made blockspace globally more desirable. Given the high cost of ETH per "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 carries inherent class attributes. Not everyone can afford Ethereum's "caviar." Some have to opt for "rice" and "potatoes" because they are cheaper blockchains.

For non-prominent blockspace, its attributes may resemble those of a "Giffen Good." "Giffen Goods" are considered necessities and non-luxury items, but theoretically, they are similar to "Veblen Goods," both having an upward-sloping demand curve, meaning demand increases as prices rise.

The theoretical existence of such goods is due to a lack of substitutes and anticipated income pressure. A good example of a "Giffen Good" is the 1845 Irish famine, where the price of potatoes rose, yet the demand for potatoes increased. Higher-quality substitutes like caviar or meat were so unattainable that even these non-luxury items became in high demand.

"Because Giffen Goods are essential, consumers are willing to pay more for them, but this also limits disposable income, making slightly higher-priced goods even more out of reach. Therefore, consumers purchase even more Giffen Goods."

Thus, Ethereum's blockspace shares similarities with other blockspaces. If someone wants to participate in the meme economy, blockspace is an essential and urgently needed commodity. However, ETH blockspace is a very expensive "lottery ticket," making the increase in demand for blockspace particularly prominent during the 2021 cryptocurrency bubble, continuing to attract capital bets. As the cryptocurrency market enters a new bull market in 2024, more economic activity is happening outside of Ethereum.

Will new blockspaces continue to exhibit Giffen Good-like attributes? Will the prices of new market participants exceed Ethereum's blockspace? What does this mean for the future of blockspace pricing?

I believe that as a broader product market suitable for blockspace emerges, the economic activities related to blockspace will gradually exhibit characteristics of both Veblen and Giffen Goods, meaning that the demand for blockspace will increase as prices rise.

The "Jevons Paradox" Regarding Blockspace

The "Jevons Paradox" is an economic paradox where the more energy consumption is optimized, the more energy is consumed. In the 19th century, William Stanley Jevons observed that more efficient steam engines led to higher coal consumption. So, will we eventually run out of blockspace?

As more efficient blockspace emerges, the demand for it is likely to increase, especially as more innovative applications fill blockspace with information. The reasoning is similar to how widening roads does not prevent traffic congestion.

Blockspace will not be fully commoditized because the quality or state of blockspace varies. Just as high-density areas with more commuters experience more severe traffic congestion, we will encounter hubs of more expensive blockspace.

Increasing block space is simple, but its essence is like building highways in the desert. Who wants to drive through the desert every day? So, this is not just about adding more block space; it also requires solving how to effectively allocate high-demand blocks.

Schedulable > Scalable

The global supply of blockspace is increasing. When the crypto industry experiences a period of activity (usually followed by mainstream media coverage), we are likely to see a surge in global blockspace demand.

During heavy load periods, whether high-status (and quality) blockspace or cheap blockspace, demand surges. More mature market participants require guarantees for blockspace delivery. As the economic value of certain transactions continues to rise, the schedulability of high-status blockspace will become much more important than the availability of any blockspace.

This is why blockspace may never become a pure commodity. Any useful use case for blockchain in the future will involve financial elements (distributed consensus is not free), so savvy participants will pay for transaction guarantees. Citadel traders and Robinhood users play different games, and the wealthy use different banks than the middle class. Blockchain participants are no exception.

The efficiency of blockspace allocation is emphasized, aiming to "……maximize the existing amount of blockspace and ensure it is allocated to the state machines that need it the most: continuously generating and allocating global consensus resources to those who need them the most. This is a mission that never wastes."

Today, we find ourselves in an insufficient balance of L2(3,4) frenzy—every new Rollup adds more blockspace. While this may be profitable in the short term (for investors and founders), the long tail of isolated blockspace with extremely unstable demand is not a sustainable way to mass-produce and allocate blockspace.

The reason is that applications require a more comprehensive and stable large-scale execution environment. The current blockspace market is fragmented and unpredictable. The mindset of "adding more blockspace" is akin to adding more bridges between crowded intersections without considering traffic lights and highway on-ramps.

This issue is likely to be resolved through market-based solutions. Blockspace, as a primitive tool, has expanded the market to many new use cases but lacks the market itself. Before blockspace has an appropriate market (including delivery and allowing for hedging), its full potential may not be realized.

We have seen examples of this in the past. In the 1970s, "hedge fund father" Ray Dalio helped McDonald's hedge the input costs of chicken nuggets through futures (a relatively new invention at the time), achieving stable costs and supply for new products. To date, the cost variations of chicken nuggets have been too great to become a viable product.

Blocks themselves need a market; they may need a real Gas cost market or a similar market. Perhaps the answer is not synthetic futures as in the above example, but we expect to see a more complex method of blockspace allocation in the future.

As demand for blockspace increases, the demand for specific execution guarantees and global blockchain allocation (rather than local chains) will also rise. In the future of the "Jevons Paradox," when it comes to blockspace allocation, we may exist in a paradigm that transcends layers. The current obsession with existing blockchains is merely a symptom of an early stage.

Given the path dependency of cryptocurrencies, the dynamic nature of design constraints, and unpredictable computational pricing, it is challenging to understand the ultimate game. Whether around blockspace/Gas exchanges, chain abstraction, or the core time model of (Polkadot), these represent preliminary ideas beyond layered design.

What truly matters is blockspace and the actual user applications that own it. Everything in between is investor-sponsored entertainment that will be abstracted over time. This is how the industry transitions from extracting value entropy to generating value negative entropy dominated by applications.

Thanks to Ankit, Hasu, Rob, Luffi, and long_solitude for their comments and feedback.

Along these lines, we have made a firm investment in Lastic—modular blockspace markets and undisclosed chain abstraction projects, supporting Biconomy since 2020 and holding DOT.