Why L1 Blockchains are Valuable

    Dan Smith and Westie

    Key Takeaways

    • The token of an L1 blockchain can derive value from being a cash flow generating asset, an in-demand gas token, the medium of exchange within the onchain economy, or respected as a store of value.
    • Blockspace profitability is determined as the total transaction fees paid by users less any fees that flow to validators/miners and token issuance distributed.
    • Value flow to holders and stakers can be used to measure the economic impact of the protocol design on both parties, especially for those who view token issuance in a PoS network as a value transfer from holders to stakers rather than a cost to the network.
    • The new Blockworks Research Analytics product tracks blockspace profitability and value flow for Bitcoin, Ethereum, Solana, Polygon PoS, and BNB with support for Avalanche launching next.

    Blockworks Analytics is officially live! We believe it is the industry’s best analytics platform for assessing the health, performance, growth, and profitability of the major protocols and ecosystems. We launched with coverage of L1s and L2s but will soon support the largest DeFi protocols as well, expanding our asset coverage over the coming months.

    This report serves as a guide to help users better understand the insights they can glean from the financial metrics displayed on our dashboards. For L1 blockchains in particular, Blockspace Profitability and Value Flow are the two major financial metrics we track.

    How L1s Derive Value 

    The valuation framework in traditional finance is largely predicated on shareholders having a legal claim on a company’s assets (to a varying degree) and cash flows (in the form of dividends). Since companies trading on well-established public markets must abide by strict accounting and reporting standards, stockholders are assured that management will act in their best interests. As such, equity valuation is a relatively straightforward process.

    This analysis focuses on general-purpose L1 blockchains, which do not have this luxury. In many ways, L1s should be viewed as an entirely new asset class more comparable to digital economies than traditional businesses. L1s are the core infrastructure enabling the creation of new-age businesses like onchain protocols.

    While an L1 token is often the currency of its economy, it does not provide token holders with a legal claim on the cash flows of the blockchain. Therefore, valuation cannot solely rely on the traditional business valuation framework. Concepts like profitability can explain a portion of an L1 blockchain’s value, but it is critical to understand there are additional value drivers for a blockchain. For a non-exhaustive list, the token can derive value from some combination of being:

    • A cash flow-generating asset (yield-bearing asset)
    • In-demand as a gas token (commodity value)
    • Used as the medium of exchange within the onchain economy (DEXs, NFT marketplaces)
    • Respected as a store of value (digital gold)

    For example, Ethereum is valuable for many reasons that factor into the valuation of ETH the asset. ETH returns cash flow to stakers with both token issuance and transaction-based yield. It sees billions of dollars in annual demand as a gas token. It is a common quote asset in the largest DEX and NFT markets. In the future, it may become a respected store of value as ultrasound money

    Thus, as Jon Charbonneau explains, running a DCF to value ETH only considers it as a cash flow-generating asset and is insufficient to determine its intrinsic value. However, the financials of an L1 blockchain still indicate its health and level of activity, which are critical inputs to determine the sustainability of a network.

    As we develop a more complete methodology that considers each value driver, this report serves as a deeper exploration into the financials of L1 blockchains.

    L1 Income Analysis

    Under the traditional framework, profit is a measure of total revenue minus total expenses. Bucketing line items as revenue or expense is typically clear-cut, but L1 blockchains do not have the same clarity. The debate mostly centers around how to classify expenses to the network, creating different perspectives as to what defines the “profitability” of a blockchain. There are two main schools of thought.

    The first sees blockchains as businesses and models profitability as total transaction fees (revenue) minus token issuance (expense). Put plainly, blockspace profitability is the total amount users are willing to pay for blockspace minus the cost to create blocks. It is imperative to take this to completion by analyzing the flow of transaction fees through the network and treating any fees paid to validators/miners as an expense to the network. For example, Ethereum transaction fees consist of the base fee and the priority fee, where the priority fee is paid directly to network validators. The priority fees are used to incentivize the creation of blocks, so they are treated as a cost of goods sold. Therefore, blockspace profitability is determined by the total transaction fees paid by users, less any fees that flow to validators/miners and any token issuance distributed.

    The second school of thought does not view token issuance as an expense to PoS blockchains, dismissing the notion of blockspace profitability. The core idea is that issuance distributed to stakers is just dilution to holders or a value transfer from holders to stakers. Since all holders have equal rights to receive new issuance by staking, value is just being redistributed within the network. In contrast, PoW issuance is still an expense because new issuance is paid to miners, which are external service providers. Since current token holders cannot opt-in, PoW issuance is similar to stock-based compensation paid to employees, as current shareholders cannot opt-in to employee compensation packages. In this more abstract view, value flow to holders and stakers is used to monitor how funds move through the network from the perspective of a token holder.

    Both concepts are geared towards tracking the health of general-purpose L1 blockchains like Bitcoin, Ethereum, Solana, Avalanche, and other similar chains. Although appchains and L2 Rollups are also blockchains, they do not necessarily fit this framework and tend to look much more like businesses built on top of a base layer rather than base layers themselves.

    As mentioned earlier, L1s are the base infrastructure that powers a larger economy, so there can be other reasons to participate in the network than just generating a profit. Businesses or protocols may be interested in running their own validator at a loss to verify blocks, align with the community, or access some inclusion guarantees. In theory, the additional cost is not prohibitive if the business accrues enough tangible/intangible value. As a concrete example, Avalanche subnet validators are forced to participate in primary network consensus in order to validate a subnet. Hence, the Avalanche primary network has additional drivers for validator participation beyond profitability.

    Although there is a path for unprofitable L1 blockchains to still be sustainable over the long run, income analysis is crucial for comparing protocol structures and understanding how different blockchains utilize revenue. Both blockspace profitability and value flows are useful for tracking this. This report analyzes both metrics and highlights how each metric can be used to better understand the design of an L1 blockchain. 

    Blockspace Profitability

    Blockspace profitability gauges the market’s willingness to transact relative to a network’s block production expenses and determines the surplus/deficit in demand. Here, we define it as the total transaction fees paid by users (revenue) less any fees that flow to validators/miners and token issuance distributed (expenses). Since protocol structure can vary greatly between L1s, blockspace profitability is useful for comparing how design choices impact the bottom line.

    Revenue is generated by transaction fees and any additional payment for inclusion (such as MEV-Boost for Ethereum). Most L1s have a unique fee mechanism and use of fee revenue within their ecosystems. For example, some fee mechanisms aim to minimize user transaction costs, while others aim to reduce fee and block size volatility. We still see a varied design space with no single dominant approach.

    Expenses are limited to fees to operate the network and token issuance. Within the major L1 blockchains, there is also no dominant fee distribution standard. Bitcoin distributes 100% of transaction fees to miners; Ethereum, Solana, Polygon PoS, and BNB each distribute a varying portion of fees to validators and burn the rest; and Avalanche distributes no fees to validators and burns 100% of fees. It may also be reasonable to consider additional hardware or electricity costs to run the network's validators, but this analysis only focuses on the onchain metrics.

    Running a profitability analysis on Bitcoin and Ethereum highlights key distinctions in the protocol design and use of revenue in each protocol. 

    Bitcoin

    For Bitcoin, the analysis highlights an unsolved issue with its fee model. Under Bitcoin’s PoW model, miners spend resources verifying transactions and creating new blocks. They are external service providers that are not required to hold BTC or participate in the onchain economy in any capacity. Bitcoin pays miners to operate the network, incentivizing participation with transaction fees and new BTC issuance.

    Transaction fees vary with market demand, but BTC issuance is programmed to halve roughly every four years. Since 2019, the network has generated between $156M and $1B of annual fee revenue but emitted between $4.7B and $15.7B of BTC issuance. Bitcoin has been unprofitable for the entirety of its 15-year existence. 
    btc profit.png

    In fact, it is impossible for Bitcoin to be profitable in its current design. Since 100% of revenue is distributed to miners, there is no remaining value before considering BTC issuance. In traditional finance, this is somewhat comparable to a business with no gross margin after considering the cost of goods sold.

    With no revenue flowing to the bottom line, the billions of dollars in BTC block subsidies guarantee a net loss. While being unprofitable does not inherently mean the network is unsustainable, it suggests BTC must derive value for other reasons. A decentralized network powering a censorship-resistant currency with a predetermined monetary policy may justify BTC as an attractive store of value.

    However, the value of issuance programmatically tapers towards zero. Transaction fees must sufficiently offset the diminished issuance at some point, or miners will become unprofitable and no longer secure the network. The decline in hash rate would weaken network security and negatively impact the “sound money” narrative, diminishing Bitcoin’s primary value driver as digital gold. 

    Ethereum 

    Ethereum has evolved significantly over its lifetime, modifying its consensus mechanism, fee structure, and issuance rates through various upgrades. Each change greatly impacted how the network generates and uses fee revenue, which is made clear by the positive impact on blockspace profitability. The reason ETH derives value has also evolved with each upgrade. Today, it can be viewed as a yield-bearing asset, in-demand gas token, and medium of exchange within DeFi and NFT marketplaces. For example, most NFT and digital collectible activity centers around the Ethereum ecosystem with ETH as the quote asset.

    The most noteworthy stages of Ethereum’s lifecycle are its PoW beginning, the implementation of EIP-1559, and The Merge. 

    PoW Era
    Ethereum’s PoW era looked quite similar to Bitcoin, with 100% of fees and new ETH issuance distributed to miners. Without a model that retained a portion of revenue, the network faced significant unprofitability. From 2015 to 2020, Ethereum ran a cumulative net loss of $7.7B. ETH was not capturing any value created by the network, and it was unclear if an ecosystem would blossom to drive commodity value as a gas token. 

    eth profit pow.png

    A New Fee Mechanism
    EIP-1559 upgraded Ethereum’s fee mechanism in August of 2021 by making the total fee a function of the base fee and the priority fee. The core focus was to reduce block size volatility to deal with transient congestion, but the design also fixed the revenue capture problem. EIP-1559 reduced the fee distribution to miners to just the priority fee, which averages 15-20% of the total fee. The upgrade also implemented the base fee burn, returning value from Ethereum the network to ETH the asset.

    If it is unclear how the burn returns value to token holders, imagine if the network kept the base fee revenue to pay developers, fund improvements to Etherscan, or simply sent it to a treasury wallet. This would look quite similar to a business using revenue to fund operating expenses. Instead, Ethereum elects to permanently remove the tokens from circulation, proportionally increasing all existing token holders’ ownership of the network.

    With the burn live, it became clear that ETH had the potential to become a yield-bearing asset. An increase in transaction activity now directly accrued value to the token. The ecosystem was exploding with onchain activity around the same time, driving demand for ETH as a gas asset. There were suddenly multiple reasons to find ETH attractive, but the issuance costs were far too high.

    The Merge
    The transition to PoS significantly reduced the amount of issuance required to secure the network. Since validators put their capital at risk, the network reaches consensus with a fraction of the electricity spend as PoW.

    In its early days as a PoW blockchain, Ethereum emitted roughly 5M ETH to miners annually. During the first year of PoS, Ethereum emitted just 670k ETH to validators, reducing annual issuance by over 80%. With 1.2M ETH in total transaction fees and 215k ETH in priority fees over the same period, Ethereum registered its first profitable 12-month period at 311k ETH ($562M). In other words, the reduced issuance combined with the EIP-1559 burn has led ETH to become net deflationary since The Merge. The table below displays Ethereum’s blockspace profitability on a quarterly basis since its transition to PoS.
    eth profit pos.png

    ETH holders can now stake ETH for a share of network rewards, improving ETH’s value capture as a cash flow-generating asset. Stakers earn priority fees, new ETH issuance, and MEV bids from MEV-Boost. MEV-Boost streamlines MEV capture and allows Ethereum to internalize the additional value of its blockspace. For the first time, we see a blockchain generating revenue beyond transaction fees. Similarly to priority fees, MEV-Boost payments are deducted from the bottom line because they are distributed to validators. 

    Value Flow

    Blockspace profitability is not meaningful to those that believe token issuance in a PoS network is a value transfer from holders to stakers rather than a cost to the network. As such, value flow to holders and stakers takes the perspective of the token holder, rather than the blockchain, to measure the change in value over a period.

    In the case of Proof of Stake blockchains, stakers are a subset of token holders because they must hold the asset to stake it. Stakers are exposed to the same value flow as holders, plus they are paid to secure the network. While issuance may be a cost to the blockchain itself, stakers do not “lose” any value since they receive the new tokens. Holders that do not participate in validation do get diluted, but any network ownership lost is gained by stakers. Value is neither created nor destroyed, it is just changing hands.

    Therefore, investors can use the value flow metrics to assess whether the token is a strong investment based on the risk/reward of being fully liquid and how much value stakers have earned. Overall, value flow gives a great view of the network from a token holder’s point of view. 

    Ethereum

    Ethereum as a PoS blockchain is profitable, but the profitability analysis does not indicate which parties accrue the value. ETH holders benefit from the burn but are diluted by ETH issuance, so the difference is the value flow to ETH holders. Stakers are paid for their participation, so the value flow to stakers is equal to the value flow to ETH holders plus priority fees, MEV payments, and new ETH issuance. Therefore, stakers are left better off largely because they earn the issuance that dilutes holders. Ethereum’s stake rate has seen consistent growth since The Merge, increasing to approximately 22% at the time of writing. We expect this trend to continue, given the millions of dollars accruing to stakers. 
    eth vf.png

    Solana

    In contrast to Ethereum, Solana runs deeply unprofitable. In 2022, the network generated $26M in transaction fees and emitted $1.45B in SOL issuance for a net loss of $1.43B. While blockspace profitability looks extremely poor, value flow analysis shows holders are bearing the brunt of the losses. Solana currently has a high staking ratio of around 71%, suggesting that holders are aware of this and avoiding dilution by staking their SOL.

    eth vf.png

    With comparatively-low value flowing to stakers, it becomes clear that Solana is not deriving profit-driven value. Solana Founder Anatoly Yakovenko has stated that Solana does not derive economic security from SOL nor should it be viewed as money. Instead, Solana is focused on creating a network that brings value to independent parties using the network. If these parties are successful, they will have business reasons to justify running a node and securing the network. 

    Final Thoughts

    L1 blockchains can derive value for multiple reasons. The valuable properties of an L1 token can include being a yield-bearing asset, in demand as a gas token, the medium of exchange within the onchain economy, or a respected store of value. Financial analysis of an L1 blockchain is a good indicator of its health and level of activity, which are critical to determining the sustainability of a network. However, it cannot be used exclusively. Financial analysis should be one part of a larger assessment that considers many paths for these assets to derive value.

    Blockspace profitability tracks the use of revenue throughout a network, but there is some debate on how to classify issuance expense for PoS blockchains. For those who view issuance as a value transfer from holders to stakers rather than an expense, value flow analysis shows how different line items impact token holders. The new Blockworks Research Analytics product tracks blockspace profitability and value flow for Bitcoin, Ethereum, Solana, Polygon PoS, and BNB with support for Avalanche launching next. 

     

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