Investment Opportunities in Ethereum Staking Extractable Value — A&T Capital

TL; DR:

ETH Staking Extractable Value can be divided into three categories: Consensus Income, Execution Income, and MEV; In the matter of flow, ETH Staking Extractable Value can be classified into two types: Validator Captured Value (Validator Staking Income) and Validator Uncaptured Value.

Validator Infra Provider, Pooled Staking Protocol, CEX and Staker can get a slice of the cake from Validator Staking Income; Searcher and Block Builder can get a share of the pie from Validator Uncaptured Value.

There are investment opportunities worthy of attention in Validator Infra Provider, Stake Pool, Products based on DVT and External MEV Market.

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Ethereum, which has been running on the proof-of-stake (PoS) consensus mechanism for almost three months since the “Merge” occurred, has taken a significant first step towards ETH 2.0.

What opportunities does this shift in the consensus mechanism present? If you want to understand the complete landscape of the Ethereum staking ecosystem, it is recommended that you read the detailed report published by our portfolio company Staking Rewards.

To understand the direct stakeholders of Ethereum staking extractable value, let’s simplify the diagram and examine the Ethereum staking extractable value chain.

Two Perspectives:

Staking Extractable Value = Consensus Income + Execution Income + MEV

Staking Extractable Value = Validator Captured Value + Validator Uncaptured Value

Classified into three types:

Consensus income: The ETH tokens newly issued by the network as a reward for honest validators participating in the consensus mechanism.

Execution income: A portion of the gas fee paid by users to proposers/builders who help package transactions on the chain.

MEV: Economic benefits generated through the execution of certain transactions, often in the form of arbitrage profits.

It is divided into two categories:

Validator captured value (validator staking income) is earned by validators as an economic incentive for maintaining the security of the Ethereum network and participating in block creation and consensus.

Validator uncaptured value is shared with other participants in the external MEV market and consists of MEV plus the execution income from external blocks, minus the MEV rewards allocated to validators.

What constitutes validator captured value (validator staking income)?

Validator Staking Income = Consensus Income + Local Block’s Execution Income + MEV Rewards

Validator staking income is composed of three sources: consensus income, execution income from local blocks, and MEV rewards.

Consensus income is the most stable and consistent source of income for validators. Execution income from local blocks and MEV rewards are more variable and are only received when the validator is selected as the proposer of a new block.

The income of the proposer depends on the circumstances. When building a local block, the proposer receives execution income. When building an external block, the block builder receives execution income and the proposer receives MEV rewards paid by the block builder.

Consensus income: The newly issued ETH tokens from the network as a reward for honest validators participating in the consensus mechanism. It can be further divided into three categories:

Proposer rewards: When a validator is selected to be a proposer and the new block they propose is accepted by the network, they will receive proposer rewards for their contribution.

Attestor rewards: Validators that are not selected as proposers can verify the correctness of the new block proposed by the proposer, and validators that participate in this verification process can receive attestor rewards.

Whistleblower rewards: If the block proposed by the proposer contains evidence of other validators violating the consensus rules, the proposer will receive whistleblower rewards.

Local Block’s Execution Income: A portion of the gas fee paid by users to proposers/builders who help package their transactions on the chain. In the case of local block building, the proposer (validator) builds the block themselves and receives all the tips in the block. This income is called execution income from local blocks.

MEV Rewards: Fees paid by block builders to proposers as part of MEV. In the case of external block building, the proposer (validator) proposes a block built by the block builder, and the fee paid by the block builder to the proposer is called MEV rewards (the block builder receives the execution income for the block). This fee may be higher than all the tips in the block (the block builder subsidizes the proposer) or it may be equal to or lower than all the tips in the block (the block builder retains zero or partial profits).

Note: After EIP-1559, the gas fee for each transaction on Ethereum is divided into a base fee and a tip. The base fee is burned and the tip is paid to the coinbase address in the block (which can be either the proposer’s or the block builder’s address).

It is important to note that currently, consensus income cannot be withdrawn and is locked in the validator’s balance on the beacon chain, while execution income and MEV rewards can be withdrawn because they have been transferred to a designated account.

How is Validator Uncaptured Value Formed?

Validator Uncaptured Value = MEV + External Block’s Execution Income — MEV Rewards

MEV: Economic benefits generated through the execution of certain transactions, often in the form of arbitrage profits.

Execution income from external blocks: A portion of the gas fee paid by users to builders who help package transactions on the chain. In the case of external block building, the builder sets the coinbase address (used to receive tips) in the block they build as their own address, so they receive all the tips in the block.

MEV rewards: Fees paid by block builders to proposers as part of MEV captured by the proposer.

Who can benefit from staking extractable value?

About Validator Captured Value:

According to the official statement of Ethereum, there are four types of staking based on how stakers choose to stake:

1. Solo staking: Staker — 100%

2. Staking as a service: Staker — 90–95%, validator infrastructure provider — 5–10%

3. Pooled staking: Staker — 90%, pooled staking protocol — 5%, validator infrastructure provider — 5%

4. Centralized exchanges: Staker — 85–95%, CEX — 0–10%, validator infrastructure provider — 5%

About Validator Uncaptured Value:

Currently, validator uncaptured value is shared by searchers and block builders, while relay has not yet extracted value from it. In theory, as a trusted relay structure and a market connecting block builders and proposers, relay has the potential for commercialization.

External MEV market architectures:

Searcher:

● Behavior: Inserts their own MEV transactions into a group of transactions to form bundles and sends them to the builder.

● Income: Proceeds from the execution of MEV transactions (MEV).

● Cost: Gas fees (base fee + tip) of MEV transactions and the fee paid to the builder.

Block builder:

● Behavior: Forms a full block based on the received bundles and transactions in the mempool, and sends it to the proposer. The coinbase address in the full block (used to receive the tip) is set to the builder’s address, and the final transaction in the full block transfers funds from the builder’s address to the proposer’s address.

● Income: Tips in the full block and fees paid by searchers.

● Cost: Fee paid to the proposer.

Relay:

● Behavior: Accepts full blocks from multiple builders and sends the most beneficial full block to the proposer.

● Revenue: No fees yet.

● Cost: Server operation and maintenance costs.

Which investment directions should we pay attention to?

● Validator infrastructure provider

● Stake pool

● Products based on DVT (distributed validator technology)

● External MEV market

Validator captured value is “the value floating on the water”. This market is relatively mature and the proportion of value extracted by each stakeholder is relatively fixed.

The two most obvious investment directions are validator infrastructure providers and stake pools, both of which A&T Capital has a presence in.

For more information on the investment logic, please refer to our previous articles:

A&T Family: Unicorn company InfStones closes a new $66 million funding round.

A&T Family: Liquidity staking solution Meta Pool completes seed round financing.

However, this market is not static and DVT (distributed validator technology) will become a new “catfish” due to its maturity and applications.

DVT assumes the responsibilities of a validator through node operators running on different hardware, making the validator more decentralized and avoiding single-point failures in hardware devices.

There can be different types of products based on DVT that are commercialized through various channels. SSV Network and Obol Network are examples of this.

SSV Network aims to create an open market that pairs stakers with node operators. Stakers can choose different node operators and simultaneously maintain a validator to prevent single points of failure. Node operators also have a certain level of redundancy and can respond more effectively to various emergencies.

Obol Network currently operates as a SaaS solution, catering to both B2C and B2B markets.

Validator Uncaptured Value is “the value hidden below the water’s surface,” and it is somewhat opaque due to its involvement in the external MEV market (off-chain).

MEV is more significant than one might think. It is derived from the profits made from the execution of certain special transactions and is complex and varied. In theory, the more active transactions on the chain, the higher the maximum MEV. Sometimes, MEV is higher than the sum of Consensus Income and Execution Income.

It is difficult to accurately measure the total amount of MEV (it is hard to determine how much profit the execution of MEV transactions has generated). However, it is almost certain that the total MEV is greater than the MEV rewards allocated to the validator.

The External MEV Market has distributed approximately 60,000 ETH to Validators since The Merge happened, and the total amount of MEV is expected to be even higher than this amount.

The MEV-Boost system developed by Flashbots has contributed to increasing decentralization among Ethereum Validators. With MEV-Boost, Validators can receive blocks from various Relays via the MEV-Boost client and choose the most advantageous one, rather than relying on a large staking pool for higher income.

However, there are a number of issues that need to be addressed in the current market:

There are many structures that require trust in the market, increasing the risk of audit.

Additionally, there is a tendency towards centralization among Block Builders and Relays.

There are several points of trust in the External MEV Market. Searchers must trust Builders to execute their transactions correctly, and Builders must trust Relays to accurately transmit their blocks. Additionally, Builders have the ability to review the Bundles provided by Searchers, and Relays have the ability to review the blocks created by Builders.

One example of this is the Flashbots Relay no longer including Tornadao Cash transactions in the blocks it submits.

We have to trust a certain subject, and what’s even worse is the increasing concentration of trusted subjects.

The data from Relayscan.io shows that, in the past week, the top five Relays accounted for more than 95%, while the top five Builders accounted for over 85%.

Some Builders offer Proposers higher fees in order to have their blocks chosen. This may be because the Builder is also a Searcher and stands to profit from the execution of special transactions. It is worth noting that this is occurring.

There are opportunities for investment in the External MEV Market.

A centralized market that requires trust is not ideal. A commercial solution that can improve the External MEV Market is worth considering as an investment opportunity.

About A&T Capital:

A&T Capital is an early-to-growth stage venture fund for emerging disruptive technologies. Led by three founding partners based out of Berlin, Singapore and Shanghai, we are supported by a global dynamic team of researchers and analysts. Our varied backgrounds in high tech, TradFi and venture capital help us understand what is essential for a startup to succeed. In 2021, we raised 100M pool of funds. Our portfolios include Amber Group, Cobo, Gnosis Safe, Nestcoin, Infstones, Consensys, and Commonwealth.

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