Economics of Hedgehog

7 min readApr 2, 2024

In our last two articles, we’ve outlined how Hedgehog Protocol is building a gas derivatives market on top of a Modular Synthetic Blockspace, and the potential it has to significantly affect every project and user.

Yet, our vision expands even further. As a modular infrastructure for onchain derivatives, our solution will extend to any onchain metric — Eigen Layer rates, Celestia DA, Bitcoin fees, and beyond.

Given the ever-present impact of onchain metrics, every user or entity connected to the blockchain will have an incentive to interact with onchain derivatives. Highlighting Hedgehog’s potential for widespread adoption.

With that in mind, we now turn our focus to a deeper exploration of Hedgehog Protocol’s economics, understanding how the supply and demand for Hedgehog Protocol will work and to perceive the incentives behind it that will ultimately attract users to use it.

Market Structure and Participants

The architecture of the Modular Synthetic Blockspace, fully described in our previous article, is what allows the Hedgehog Protocol to integrate complex market mechanisms of the Ethereum ecosystem into a straightforward derivatives market.

This architecture hinges on three critical components: Hedgehog Oracles, Collateralized Debt Positions (CDPs), and a carefully structured fee system. Oracles play a pivotal role, sourcing and submitting onchain Base Fee data to ensure market operations are based on accurate and reliable information.

This foundational data enables the minting of BaseFee tokens through CDPs, where users leverage Wrapped Staked Ether (wstETH) as collateral to participate in the gas fees derivatives market. The architecture simplifies the complexities of blockspace and gas fees, turning them into tradable assets that reflect the intricate dynamics of supply and demand.

Furthermore, the protocol’s fee structure — comprising redemption, liquidation, minting and dynamic fees — ensures the ecosystem’s health, sustainability and equilibrium. These fees incentivize behaviors that align with the protocol’s viability, such as maintaining collateralization ratios and efficiently managing liquidations.

The Hedgehog Protocol’s architectural design not only abstracts away the complexities inherent in blockchain transactions but also creates a robust framework for new market opportunities. It enables users to hedge against gas price volatility, speculate on future prices, and engage in a market previously beyond their reach.

Participants

There are four main different market participants that can be described as Hedgehog users — Liquidity Providers, Minters, Traders and Arbitrageurs. Each participant type plays a critical role in ensuring the protocol’s functionality and market efficiency.

Liquidity Providers (LPs)

Liquidity Providers are the backbone of the Hedgehog Protocol, injecting liquidity into the system by depositing assets into AMM pools. These participants are incentivized through transaction fees and, in some cases, demand-based fees. By supplying liquidity, they enable smoother trading for the Base Fee tokens. LPs take on the risk of impermanent loss but are crucial for maintaining a fluid and efficient market.

Minters

Minters are participants who create new tokens by locking up collateral in Collateralized Debt Positions (CDPs). In the context of Hedgehog, Minters can add wstETH as a collateral to mint base fee tokens, be it to speculate on future gas price movements or hedge against them. Minting tokens require an understanding of the Ethereum gas market and a willingness to engage with the protocol’s mechanisms to manage the risks and rewards of their positions.

Traders

Traders actively buy and sell gas fee derivatives on the Hedgehog market, seeking to profit from price fluctuations. They rely on a variety of strategies, ranging from long-term speculation based on market trends to short-term arbitrage opportunities. Traders are essential for the market’s liquidity and price discovery processes, and their participation is fundamental to reflect the real-time market sentiment regarding Ethereum’s gas fees.

Arbitrageurs

Arbitrageurs specialize in finding and exploiting price discrepancies across different markets or within the market itself. In the Hedgehog ecosystem, they play a pivotal role in ensuring that the prices of gas fee derivatives remain fair and in line with underlying market conditions. By buying underpriced and selling overpriced tokens, trading them against the protocol rates, Arbitrageurs help correct mispricings and contribute to market efficiency.

These roles are not mutually exclusive, and participants can switch between them or perform multiple roles simultaneously based on their strategies and market conditions. The dynamic interaction between Liquidity Providers, Minters, Traders, and Arbitrageurs creates a robust and vibrant gas fees market.

Economic Benefits

While the intrinsic volatility of gas fees can be problematic for those depending on them for daily operational or trading costs, when we make them tokenized and tradable they become an excellent opportunity. The Hedgehog Protocol harnesses this volatility to mitigate these challenges. Let’s examine them in more detail:

Cost Reduction and Predictability

The Hedgehog Protocol introduces a novel approach to managing and mitigating the unpredictability associated with gas fees. By tokenizing gas fees and creating a market for these tokens, the protocol enables users to lock in future gas prices, thereby offering a mechanism for cost reduction and predictability.

Hedging Against Volatility: Users can mint base fee tokens when prices are high, essentially shorting gas fees. This hedging mechanism allows users, especially those with predictable contract interactions, to manage their costs more effectively, profiting from the peaks of gas price surges.The idea is straightforward: Users mint BFEE, sell them at an AMM and buy back when the price is low, closing their trove.

One important aspect to notice are the Dynamic Fees, as we’ve explained in the What is Hedgehog article, they ensure that collaterals are not exhausted in episodes of gas fee spikes or downturns. In other words, they make sure that obvious trades are not as obvious and the market stays competitive converging to the baseFee ‘spot price’.

Chart 2: Gas fees hedging and dynamic fees illustrated

Chart 2 illustrates this scenario, where gas fees spike, when the trade would be obvious and everyone would try to ‘short’ the gas fees. With the dynamic fees (described by the pink area) in place, the market stays competitive.

Gas Trading: Essentially buy low, sell high. Until now, this wasn’t possible, and it is a trade that almost everyone in this space has thought of before, with the volatility introducing several trading opportunities every day. Base Fee tokens will be tradable on AMMs.

An important feature of this market is that the price depends explicitly on the secondary market liquidity and state. And we can expect that it will likely be arbitraged with the protocol’s rates, because of that it is safe to assume that, on average, the base fee prices negotiated in the AMMs might be even more smoothed than the 50-block moving average.

Enhanced Budgeting: For projects and developers, the predictability offered by the Hedgehog Protocol allows for more accurate budgeting and financial planning. This stability is crucial for the long-term sustainability of projects built on Ethereum.

Imagine a project that has to constantly interact with other contracts spending gas fees. These interactions are represented by the purple dots all over the base fee chart. The problem is clear to see, the costs are as volatile as the gas fee itself, it is hard for projects to project how much they’ll spend over time as costs are so volatile.

By incorporating Hedgehog hedging and/or trading strategies, these projects can lock-in their costs, making them predictable, regardless of current or future market conditions, as described on Chart 5. This a tremendous step for long term projections and health of blockchain companies.

Chart 5: Constant gas costs, hedged using Hedgehog illustrated

In essence, while the volatility of gas fees presents challenges, the Hedgehog Protocol transforms these challenges into opportunities for cost management, predictability, and financial innovation. Through its unique approach, the protocol not only addresses a critical need within the Ethereum ecosystem but also paves the way for further advancements in onchain derivatives.

Conclusion

We turn our attention to the economic implications, particularly focusing on how users and projects can leverage gas fee volatility to their advantage. At its core, Hedgehog’s innovative approach to creating a derivatives market for gas fees allows for hedging against volatility, providing a unique opportunity for users to manage and even profit from the fluctuating costs of transactions. By tokenizing gas fees, Hedgehog transforms a variable and often unpredictable expense into a tradable asset, enabling users to lock in prices or speculate on future fee movements.

Liquidity Providers, Minters, Traders, and Arbitrageurs play pivotal roles within this ecosystem, each capitalizing on market movements in different ways. As we’ve mentioned, Minters might use their insights into the gas market to mint tokens when fees are high, selling them, and buying back as prices are low, while Traders and Arbitrageurs seek profits from short-term price discrepancies. These dynamics create a vibrant market around Ethereum’s gas fees, turning what was once a hindrance into a potential source of profit and strategic financial management.