The MEV opportunity
Since the start of 2021, MEV has funneled in excess of $675m from ordinary DeFi users to those searching for opportunities, and those who validate them. In this newsletter we will dive into what the never-losing, ever-growing MEV sector is, how it works and whether it is a benefit or a detriment to the overall health of the crypto ecosystem.
As long as value-changing transactions take place on a transparent blockchain, there is likely to be some sort of MEV available to extract. MEV is not limited to Ethereum, similar methods and processes can be used on other chains to extract MEV. Arbitrage, liquidations and other forms of MEV will always play an intrinsic part of a healthy decentralised finance ecosystem. MEV incentivises ‘searchers’ to look for inefficiencies like price discrepancies between Dex’s and to process liquidations efficiently, which contribute to a healthy functioning Defi ecosystem.
Is MEV unique to crypto?
One can think of MEV as the emergent value that comes from having users generating transactions that are tied to some sort of economic activity. The thinking being that one can attach value to order flow and extract some sort of benefit from these transactions tied to economic activities. In traditional finance, when you look at retail platforms like RobinHood, transactional activity from users have some form of information content in them and that information is invaluable to entities like hedge funds or market makers that know how to turn this information into profit. The concept of MEV is not new, Trad-fi has been using this for a long time and it can be summed up as “Actors that are in a privileged position to see transactions and operate on top of them to extract some sort of value”. While it is not always legal to act on this information in Trad-fi, the crypto space is mostly unregulated and actors in privileged positions take advantage of this.
What is MEV?
Maximal Extractable Value (MEV) is the profit a block proposer (Validator) can make by reordering, excluding or including transactions from the blocks that they produce. It is value that can be extracted in excess of the standard block reward and gas fees. MEV was originally captured by PoW miners since they controlled the order, inclusion and exclusion of transactions but this responsibility has now shifted to validators.
Understanding the MEV Supply Chain
The typical flow of a transaction and the various participants in the ‘value chain’ is best described in an example of a user swapping their tokens on the Uniswap Dex. Suppose a user wants to swap their ETH for USDC using Uniswap and this transaction contains MEV that can be extracted.
The user has the intent to make the swap
The user connects their wallets and signs the transaction to swap their ETH for USDC
A searcher picks up this transaction that contains an MEV opportunity and bundles it with other transactions and submits it to a builder
A builder constructs a ‘payload’ using transactions received from users and searchers and then send it to relayers
Relayers route execution payloads to block proposers
Validators (Block Proposers) receive these execution payloads and proposes the most profitable block to the Ethereum network for attestation and block inclusion
1 - Users
Users represent ordinary people making transactions on the network or anyone that has the intention to enact a state transition on a blockchain.
2 - Wallets
Wallets are the interface through which users submit their transactions and express their intent to interact with a blockchain. This includes everything that sits at the application layer including smart contract protocols and dApps. The developers of these protocols and dApps decide how the transactions will be routed, whether they go to a public transaction pool or rather through a private routing system like Flashbots Protect. Developers therefore decide how to deal with potential MEV that arises when they build the protocol, dApp or wallet.
Wallets could sell their order flow to searchers and agree to route all of their flow to specific searchers in exchange for splitting the MEV revenue that gets generated from that order flow. This is a very traditional model and is not the best way to approach it and leans more to a centralised approach, participants in this step of the supply chain need to develop more decentralised options like open market places for order flow.
3 - Searchers
A searcher is an independent network participant that runs algorithms to detect profitable MEV opportunities and uses bots to submit these profitable transactions to the network. Searchers play a critical role in a healthy decentralised finance market. Lending markets rely on collateral to be liquidated to recapitalise underwater markets. A Dex relies on arbitrage traders to keep their prices in line with the rest of the market and to provide a good trading experience.
The validators receive a portion of this MEV because the searchers pay higher gas fees (which go to the validator) to make sure that their transactions are included in a block. Searchers will convert all these profitable MEV transactions into something called a ‘bundle’, a bundle is a group of transactions that are grouped together and then sent to block builders.
4 - Builders
Builders play the role of aggregating various bundles that are submitted by searchers and then construct it into a block. Block builders aggregate these bundles into something called ‘execution payloads’ which optimise for MEV extraction and the fair distribution of rewards, these are then sent to relayers.
5 - Relayers
Relayers aggregate execution payloads from a number of different builders to select the block with the highest possible fees.
6 - Validators (Block proposers)
Validators receive these blocks from relayers and select the most profitable block to broadcast it to the Ethereum network for attestation and block inclusion.
The MEV-Booster shot
MEV-Boost is open source middleware that has been developed by the Flashbots team for Proof-of-Stake Ethereum. Validators running the software on their consensus clients can boost their staking rewards by selling blockspace to an open market of ‘builders’. Builders collect transactions, reorder them into a particular order and submit them into a block that is sent to block proposing validators. The validators that connect their consensus client to MEV-Boost get access to full blocks from a network of block builders optimised for MEV extraction. Flashbots claim that this can increase validator rewards by more than 65% and increase the staking APR quite dramatically.
What is the difference between MEV-Boost and normal block construction?
Validators that choose not to run MEV-Boost would get blocks from their local execution client, which is limited to receiving transactions from the public mempool. Transactions from the public mempool are not optimised for MEV extraction which will likely result in lower rewards for validators.
The duties of Validators change under MEV-Boost
Flashbots define a block proposer as a “validator that has been pseudorandomly selected to build a block for a given slot in an epoch (there are 32 slots per epoch)”. The block proposers are chosen from a validator set using the standard RANDAO mechanism. Block proposers have a slightly different role with MEV-Boost, the original role of block proposers was to
Build the best (most profitable) block from all available transactions
Propose this block to the PoS network
MEV-Boost simplifies the role of a validator to proposal duties only:
Receiving a block from their local execution client
Receive an execution ‘payload’ from a relayer and blindly sign a block without seeing the content of the block (i.e. the blinded transactions that are escrowed by the relay)
Why should Validators run MEV-Boost
MEV creates an incentive for block producers to vertically integrate with entities like trading firms or entities with large order flows to boost their returns. This is due to the inherent role of a block producer, where they need to build the best (most profitable) block from all transactions available to them and also propose this block to the network. The problem with vertical integration is that it can be a centralising force for the Ethereum network.
In a proposal brought forward by Vitalik Buterin, Justin Drake and the Flashbots team - the concept of proposer-builder separation (PBS) was presented as a solution to this centralisation vector. PBS separates the role of proposers from block builders.
Block proposers do not need to try and produce a revenue-maximising block themselves
They can rely on an outside market of competitive block builders that produce full blocks that are optimised for MEV extraction and the fair distribution of rewards.
Validators can access blocks from a marketplace of builders to promote greater competition amongst builders
The entire proposal promotes more decentralisation, censorship resistance and competition for Etheruem. There are a few key benefits of running MEV-Boost which were outlined in detail in the Flashbots article.
Competition amongst builders benefits everyone
As more block builders compete to buy blockspace from validators, the more they have to bid to validators. Consequently, validators will earn higher returns and can boost their revenue in addition to block rewards. MEV revenue will become even more important for validators as Ethereum is planning a reduction in block subsidies in the future.
A competitive block building market can also help improve Ethereum’s resistance to censorship. Builders that choose to censor transactions will make less money than non-censoring builders and therefore not be able to bid as much to validators.
MEV-Boost is neutral infrastructure
Builders can use whatever ordering approach they deem fit, MEV-Boost is unopinionated about the ordering approach that builders use. Mev-Boost is compatible with any Ethereum client, which is a leap forward from the MEV-Geth under PoW Ethereum that resulted in most users opting for Mev-Geth and throwing client diversity best practises out the window.
MEV-Boost prevents ‘MEV Hiding’ - A key risk factor raised in the run up to PoS Ethereum
Staking pools like Lido and Rocketpool continue to grow rapidly and the appetite for liquid staking solutions doesn’t seem to be slowing down. Assuming most of the stake in Ethereum will be delegated to staking pools, these pools will then delegate the stake to their node operators. Depending on the type of staking pool this can be delegated to trusted or trustless node operators. The risk is that node operators are incentivised to hide the real profit they make from a block and to rather keep a portion of that for themselves.
MEV-Boost eliminates this risk through PBS by creating an open market for builders to compete. The competition ensures that builders will always need to maximise their public bids in order to compete with other block builders. If validators continue to sell their blockspace to the highest public bid from builders, it is very likely that they are not hiding MEV.
How could MEV evolve going forward?
If you had to come up with a principle called the ‘Law of the conservation of MEV’:
Any MEV that exists and can be extracted, will be extracted.
If you view the future through this lens, we know that as long on-chain transactional activity remains, MEV will remain. The question however is what are the negative externalities that come from the extraction process of the MEV? In its current state, users are worse off because of MEV activities when you consider the financial loss they incur as a result of frontrunning, increased transaction costs and failed transactions. Depending on the chain, the extraction mechanism could also be to spam the network which can result in an entire network being brought down (Solana) and ruin the user experience for most ordinary market participants that may just be trying to get into an NFT launch.
MEV needs to move toward rewarding users and returning the value captured to users to create an open and fair marketplace for competitive behaviour. Presently value gets returned to users through MEV-Geth and MEV-Boost on Ethereum by maximising the value that stakers get from producing blocks. However, users actually pay this themselves through gas fees and also MEV which goes toward paying for the blockspace - so is value really being returned to users?
Stephane Gosselin hinted that there is a future where the user can capture the MEV directly. An example of this has been RFQ systems which aggregate transaction flow and then also route it to market makers directly who were able to quote better prices than the Dex’s directly. Stephane explained that this is a way to optimise for trade execution in a way that returns value to the user. Over time, the expectation is for there to be more generic approaches to this and even a future where users are paid to transact on a chain rather than having to pay the transaction fee. In this world, the information value of a user’s transaction is greater than the transaction fee. While this is a brain teaser and difficult to wrap your head around, the MEV space is becoming more important and cannot be ignored anymore. It affects most parties in the supply chain and it needs to be taken into account to provide the best user experience possible.
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