Congestion Price Discovery

Vol #51 - September 3rd, 2021

Nobody ever goes there anymore; it’s too crowded.

Yogi Berra’s quip describes very well the experience that Ethereum users have been having over the past several weeks. The network has been so jammed with users creating and trading NFTs, that many other applications are getting squeezed out. 

The beauty of the Ethereum blockchain is that the network itself is Turing Complete. This concept comes from the legendary mathematician Alan Turing who defined a programming language as complete if it could solve any computational problem accomplishable by computers. 

Most programming languages are Turing complete, and it means they can build applications from spreadsheets to video games. Bits and bytes can serve almost any master with enough ingenuity and skill. 

The flexibility of Ethereum’s Virtual Machine and smart contract platform means that any application can be built on top of the blockchain and rely on its security and decentralization. Anything with an “if>then” logic can be automatically enforced in a completely trustless manner.  

All these different applications from loan protocols to jpegs of rocks use the same “computer” to process their transactions. For these transactions to be completed, they need to be mined as part of the next block that gets added to the chain. Adding that block and recording the transaction forms the immutable record of ownership.

With everyone competing for that block space, there needs to be a method to allocate the relatively scarce resource of computing power. Gas or gwei is how the Ethereum network charges different users and rewards the accountants updating the ledger and spending processing power. 

There is much debate about how to best charge and adjust gas fees. A recent network improvement called EIP-1599 adjusted the structure to be more predictable. It’s come at a time of very high network usage, and not all protocols have made the shift. 

A major conversation in the space is around what are broadly defined as scaling solutions. There are “layer 2” solutions, where a process separate from the Ethereum blockchain processes and aggregates transactions that get bundled into a single transaction. This relies on complex cryptographic tools called Merkle Trees.  

Another class of solutions is to re-architect an entirely different blockchain for specific purposes. While Ethereum is generalized and emphasizes security, there are blockchains that claim to be more energy efficient like Cardano, or those which excel at throughput and speed. Solana has been making waves over the past few weeks as users are realizing the potential of a multi-threaded chain designed to process transactions on par with the NYSE. 

While there are several different competitors on both fronts, all of these projects are in relatively early stages of development. There’s a VHS<>Betamax war happening on dozens of fronts. Ultimately these alternatives take time to evolve, and evaluating the tradeoffs of rapidly evolving projects is a very difficult exercise in handicapping.

Blockchain technology is still in its infancy, and is still finding the appropriate balance between the various use cases. If decentralization is an absolute priority, then there must be sacrifices made in the use of energy required to secure the network. Lower cost transactions are good for users, but they provide low incentives for the miners who process the transactions. 

As the economics shift, the price discovery process must work in real time. Users are willing to spend hundreds of dollars in gas fees to process a single transaction because the NFT they just minted could sell for many multiples of that. If that rate becomes the benchmark for the cost of gas, then certain use cases will become uneconomical - high frequency transactions for example - and migrate to other venues. 

Network effects are extremely powerful, and will be one of the driving forces that determines the ‘winner’  in this competition for users and security.  But they can have unintended consequences for marginal users who get boxed out by flurry of activity from new users.

All markets are fundamentally about price discovery. Active and liquid markets tend to be deemed efficient because they are constantly updating prices based on new inputs. The price of a gallon of traditional gas is a good example. With razor thin margins, every time the cost of a barrel of West Texas Intermediate moves, so does the price at the pump. 

The wild swings in gas prices on the blockchain reflect how new the technology is. The founder of Ethereum himself said earlier this week that the most surprising use case has been NFTs. This wildly popular mania today was not even conceivable 6 years ago when Ethereum first launched. 

Watching price discovery happen is fascinating. It keeps technologists and practitioners constantly on their toes looking for new opportunities. As Jeff Bezos said - your margin is my opportunity.