Introduction to Solana's Fee Market Challenges

Solana, known for its high-speed and low-cost transactions, has been facing scrutiny over its local fee market mechanisms. In a recent episode of the Lightspeed podcast, Eugene Chen, co-founder of Ellipsis Labs, Phoenix Protocol, and Umbra Research, delved deep into the intricacies of Solana's transaction processing and fee structure. Chen, widely regarded as one of the sharpest builders in the Solana ecosystem, provided valuable insights into why Solana's local fee markets aren't functioning as advertised and proposed potential solutions to enhance the network's efficiency.

Understanding Solana Transactions

To comprehend the challenges facing Solana's fee market, it's crucial to understand how transactions work on the network. When a user initiates a transaction, such as a swap on Jupiter, the process involves several steps:

1. Jupiter creates a transaction that is sent to the user's wallet (e.g., Phantom) for signing.
2. Once approved, the signed transaction is forwarded to the wallet's RPC (Remote Procedure Call) node.
3. The RPC node then sends the transaction to a validator.
4. The validator forwards the transaction to the current leader (the validator elected to build the current block).
5. The leader processes the transaction through various stages, including network layer throttling and the banking stage (block builder).

This process, while efficient, introduces complexities that affect how transactions are prioritized and included in blocks.

Continuous Block Building on Solana

One of Solana's distinctive features is its continuous block building process. Unlike Ethereum, where blocks are built discretely every 12 seconds, Solana's leaders continuously build and execute blocks as transactions arrive. This approach offers several advantages:

• Faster pre-confirmations for users, not limited by block times
• Potential for near-instant transaction confirmations (as fast as one round trip between client and leader)
• More efficient use of block space

However, this continuous approach also introduces challenges in implementing effective local fee markets.

The Myth of Solana's Local Fee Markets

Eugene Chen's provocative statement that "Solana's local fee markets aren't real" stems from the current implementation's inability to provide guaranteed prioritization based on fees alone. While Solana's design includes features intended to support local fee markets, such as the 48 million compute unit limit per block and the 12 million compute unit limit per account, these mechanisms don't function as effectively as intended.

The reasons for this ineffectiveness include:

1. Probabilistic inclusion: Due to the continuous block building process, a high-fee transaction sent late in a block's construction might not be included, regardless of its fee.
2. Multi-threaded execution: Solana uses four threads for transaction processing, which can lead to inconsistent ordering based on account locks rather than fees.
3. Lack of a true market mechanism: The current priority fee system doesn't provide clear signals to users about the required fee for inclusion.

The Priority Fee Conundrum

Solana's current priority fee system allows users to set a single priority fee for their transactions. However, this system has several limitations:

• Users have no clear indication of what priority fee to set for guaranteed inclusion.
• The first-price mechanism leads to inefficiencies and overpayment.
• There's no mechanism for users to express "willingness to pay" up to a certain amount for fast inclusion.

These issues become particularly apparent when blocks are full, leading to a suboptimal user experience and potential transaction failures.

Proposed Solutions for Solana's Fee Market

Eugene Chen outlined several potential improvements to Solana's fee market:

1. Dynamic base fees: Implement an escalator mechanism that increases the base fee when blocks are consistently full, similar to Ethereum's EIP-1559.
2. Compute unit-based pricing: Adjust fees based on the amount of compute units a transaction uses, rather than a flat fee per signature.
3. Account-specific pricing: Introduce dynamic pricing for frequently accessed accounts to better manage congestion.
4. Improved scheduler mechanisms: Enhance the transaction scheduler to reduce jitter and improve fee-based prioritization.

These changes could significantly improve user experience, reduce spam, and create a more efficient fee market on Solana.

MEV on Solana: Challenges and Opportunities

Maximal Extractable Value (MEV) is another crucial aspect of blockchain economics that Chen discussed. MEV refers to the value that can be extracted by reordering or including/excluding transactions within a block. On Solana, MEV dynamics differ from Ethereum due to the continuous block building process and the lack of a public mempool.

Key points about MEV on Solana:

• Searchers (entities looking for MEV opportunities) have less visibility into pending transactions compared to Ethereum.
• The continuous block building process makes traditional sandwich attacks more challenging but not impossible.
• Jito, a Solana validator client, has introduced a form of discrete block building that allows for more traditional MEV extraction methods.

Chen emphasized that while MEV can be problematic for users, it's currently a much smaller issue on Solana compared to Ethereum, primarily due to the lower overall fees and different market structure.

Application-Specific MEV and Value Accrual

An intriguing topic Chen touched upon was how applications could potentially accrue some of the value typically captured by validators through MEV. He noted that this is a complex and opinionated subject, as it raises questions about who truly owns the blockspace and deserves the economic benefits of controlling it.

Some potential approaches for applications to reduce MEV exposure include:

• Implementing dynamic liquidation fees (like Aave v3 and Euler Finance)
• Creating internal auction mechanisms for critical operations
• Designing protocols that inherently minimize MEV opportunities

Chen stressed that application developers should focus on reducing "leakage" to MEV rather than trying to capture it themselves, as this generally leads to better outcomes for users.

The Importance of Infrastructure Understanding for Developers

One of the most compelling arguments Chen made was for the necessity of application developers to deeply understand the underlying blockchain infrastructure. He stated, "I think it's incredibly important for application developers to understand the infra. I think there's some potential future world where all of the infra is actually perfect and you can have these like mental abstractions. None of the blockchains are there. None of the blockchains are even closer there. Solana is definitely not there yet."

This understanding allows developers to:

1. Build better applications that serve users more effectively
2. Optimize for Solana's unique characteristics and limitations
3. Contribute to the improvement of the overall ecosystem

Chen's work with Umbra Research aims to bridge this knowledge gap by providing comprehensive explanations of how Solana works, making it accessible to researchers and developers from other blockchain ecosystems.

Ellipsis Labs and Phoenix Protocol: Innovating on Solana

Eugene Chen's company, Ellipsis Labs, is at the forefront of DeFi innovation on Solana. Their flagship product, Phoenix Protocol, is a next-generation limit order book designed to overcome the limitations of previous implementations like Serum.

Key features of Phoenix Protocol include:

• Uninscentivized liquidity provided by professional market makers
• Focus on sustainable and profitable liquidity provision
• Improved architecture leveraging Solana's unique capabilities

Chen emphasized that Phoenix aims to deliver a "step function improvement" over existing DeFi liquidity solutions, particularly in high-throughput, low-fee environments like Solana.

The Future of Solana: Challenges and Opportunities

As Solana continues to grow and attract more users and developers, several key challenges and opportunities emerge:

1. Improving documentation and accessibility for developers
2. Balancing between different use cases (DeFi, NFTs, gaming, etc.)
3. Enhancing cross-chain interoperability
4. Continuing to optimize for scalability and performance

Chen expressed optimism about Solana's future but stressed the importance of ongoing improvements and community engagement to maintain its competitive edge in the blockchain space.

Conclusion: Solana's Path Forward

Eugene Chen's insights provide a valuable perspective on Solana's current state and future potential. While challenges exist, particularly in the realm of fee markets and MEV management, the Solana ecosystem appears well-positioned to address these issues through continued innovation and collaboration.

As the blockchain space evolves, Solana's focus on high performance and low fees, combined with the efforts of builders like Chen and the Ellipsis Labs team, suggest a bright future for the network. However, the success of Solana will depend on its ability to adapt to changing market conditions, improve its infrastructure, and continue attracting talented developers and projects to its ecosystem.

The conversation with Eugene Chen underscores the complexity of building efficient, user-friendly blockchain systems. It also highlights the ongoing need for research, experimentation, and open dialogue within the crypto community to solve these challenges and push the boundaries of what's possible in decentralized finance and beyond.

Facts + Figures

• Solana transactions are processed through four main threads for user transactions and two additional threads for vote transactions.
• A single Solana block has 48 million compute units available, with a maximum of 12 million compute units per account.
• Phoenix, Ellipsis Labs' limit order book protocol, is among the top 10 DEXs by trading volume across all blockchains.
• Over 53% of transactions landing in Solana blocks were failed transactions as of January 2023, primarily due to spam from arbitrage and liquidation attempts.
• Solana block times are approximately 400 milliseconds, significantly faster than Ethereum's 12-second block times.
• Jito, a Solana validator client, has introduced a 200-millisecond discrete auction mechanism for MEV extraction.
• Solana's base fee is currently set at a constant 5,000 lamports per signature, approximately 0.003 cents per transaction.
• Solana transactions can use up to 1.4 million compute units, regardless of the base fee paid.
• Coinbase staking has more than 10% of Ethereum's stake, despite charging a 25% commission on staking rewards.
• Access Protocol, mentioned in the podcast, has 225,000 users reading content, receiving NFTs, and interacting with creators.

Questions Answered

How do Solana transactions work?

Solana transactions go through a multi-step process. First, a transaction is created and signed by the user's wallet. It's then sent to an RPC node, which forwards it to a validator. The validator sends it to the current leader, who processes it through various stages including network throttling and the banking stage (block builder). This continuous block building process allows for faster pre-confirmations and potential near-instant transaction confirmations.

Why aren't Solana's local fee markets functioning as intended?

Solana's local fee markets aren't functioning as intended due to several factors. The continuous block building process makes it difficult to guarantee high-fee transactions will be included, especially if sent late in a block's construction. The multi-threaded execution can lead to inconsistent ordering based on account locks rather than fees. Additionally, the current priority fee system doesn't provide clear signals to users about the required fee for inclusion, leading to inefficiencies and potential overpayment.

What solutions does Eugene Chen propose for improving Solana's fee market?

Eugene Chen proposes several solutions to improve Solana's fee market. These include implementing dynamic base fees that increase when blocks are consistently full, similar to Ethereum's EIP-1559. He also suggests adjusting fees based on the amount of compute units a transaction uses, rather than a flat fee per signature. Additionally, Chen recommends introducing dynamic pricing for frequently accessed accounts and enhancing the transaction scheduler to reduce jitter and improve fee-based prioritization.

How does MEV (Maximal Extractable Value) differ on Solana compared to Ethereum?

MEV on Solana differs from Ethereum primarily due to Solana's continuous block building process and lack of a public mempool. This makes traditional MEV extraction methods, like sandwich attacks, more challenging but not impossible. Searchers have less visibility into pending transactions on Solana. However, innovations like Jito's discrete block building mechanism are introducing more traditional MEV extraction opportunities to Solana. Overall, MEV is currently a smaller issue on Solana compared to Ethereum, due to lower overall fees and different market structures.

What is Phoenix Protocol and how does it innovate in the DeFi space?

Phoenix Protocol, developed by Ellipsis Labs, is a next-generation limit order book designed for Solana. It innovates by focusing on uninscentivized liquidity provided by professional market makers, emphasizing sustainable and profitable liquidity provision. Phoenix aims to deliver a significant improvement over existing DeFi liquidity solutions, particularly in high-throughput, low-fee environments like Solana. It leverages Solana's unique capabilities to offer better pricing and more efficient trading compared to traditional AMM models.

Why does Eugene Chen emphasize the importance of infrastructure understanding for developers?

Eugene Chen emphasizes the importance of infrastructure understanding for developers because it enables them to build better applications that serve users more effectively. Understanding the underlying blockchain infrastructure allows developers to optimize for Solana's unique characteristics and limitations, and contribute to the improvement of the overall ecosystem. Chen argues that no blockchain has reached a level of perfection where developers can rely solely on abstractions, making it crucial for them to deeply understand how the system works to create optimal solutions.

What are the main challenges Solana faces in its future development?

The main challenges Solana faces in its future development include improving documentation and accessibility for developers, balancing between different use cases (DeFi, NFTs, gaming, etc.), enhancing cross-chain interoperability, and continuing to optimize for scalability and performance. Additionally, Solana needs to address its fee market issues, improve MEV management, and ensure that its infrastructure can support the growing demand while maintaining its high-speed, low-cost transaction promise.

How does Ellipsis Labs contribute to the Solana ecosystem?

Ellipsis Labs contributes to the Solana ecosystem through its flagship product, Phoenix Protocol, and through research and development efforts. Phoenix Protocol aims to provide superior liquidity solutions in DeFi, leveraging Solana's high-throughput, low-fee environment. Additionally, through Umbra Research, Ellipsis Labs produces comprehensive explanations of how Solana works, making it more accessible to researchers and developers from other blockchain ecosystems. This educational effort helps bridge knowledge gaps and fosters innovation within the Solana community.