MEV on Ethereum
The Past, The Present & The Future
Every transaction on Ethereum relies on consensus providers (miners/validators) as intermediaries to validate and execute transactions on the blockchain. These consensus providers validate transactions by ordering them on the blockchain based on the gas fees paid for the transaction. A consensus provider would prefer adding a transaction that pays a higher gas fee to them.
Owing to the public and transparent nature of Ethereum, anyone who can access the mempool can also front-run trades and sandwich them to make profits known as the maximum extractable value or MEV. A mempool, in simple terms, is a waiting area for transactions that haven’t been added to a block and are still unconfirmed.
As seen in the diagram above, a user submits a transaction which gets added to the mempool. MEV searchers look for arbitrage opportunities to send transactions in the mempool with a premium gas fee to get preferential ordering on the blockchain. Once done, the consensus provider checks the transactions and adds them to the block in descending order of gas fees to maximize their profits. Once the transaction takes place, both the MEV searcher and the consensus provider have maximized their returns in that transaction.
Who extracts this value?
In theory, the MEV value must accrue to consensus providers who have placed the transactions in the block added to the blockchain. However, a large portion of MEV is extracted by independent searchers who run complex algorithms to identify potential MEV on the blockchain. These searchers then submit those transactions to the network so the miners can pick them up to make profits. Searchers in this case, pay up to 100% of the searcher’s MEV as a gas fee, thus increasing the likelihood of inclusion of their transaction on the blockchain. Miners, being rational, choose to include transactions with the highest gas fees.
For an MEV strategy that is easy to execute (DEX arbitrage) and more competitive, searchers pay gas fees closer to 100% compared to less competitive strategies. With gas prices being the same for everyone who is submitting a transaction at a particular point in time, the only way to reduce gas fees is by reducing gas used. This could be done through gas golfing. A few well-known gas golf techniques include: using addresses that start with a long string of zeroes, since they take less space (and hence gas) to store; and leaving small ERC-20 token balances in contracts since it costs more gas to initialize a storage slot.
Considering searchers and consensus providers, of the 432.87k ETH that has been collected as MEV almost 74% of it goes to searchers and the remaining 26% goes to the miners.
Who will claim a greater proportion of the MEV depends on the demand and supply of searchers and consensus providers. As more people become aware of this opportunity and employ similar strategies, searchers will have to pay a higher proportion of their MEV as gas fees to ensure their transactions are added to the blockchain.
As seen above, the average miner percentage in MEV has gone down with increasing competition.
Before we dive deeper into the qualitative aspects of MEV, let us check out some stats about MEV.
Exploring MEV
As of June 20 2022, more than 432.87k ETH has been extracted as MEV since 1 January 2020 and 5.25% of that amount has come in the last 30 days. This value is lower than what the actual maximum value extracted could be and is limited to a limited number of 10 DeFi protocols on Ethereum, with Uniswap V2 being the biggest contributor to MEV. This is therefore the lower bound estimate of MEV that has actually been extracted to date.
The average MEV therefore extracted daily is 479 ETH.
Of this total MEV income, 79% has been extracted from traders on Uniswap (V2 and V3), which is one of Ethereum’s largest DEX in terms of trading volume.
MEV on Uniswap
As one of the largest DEXes in the space, in terms of trading volume, we can see that V3 contributes more to the trading volume in comparison to V2. That’s because concentrated liquidity involves much more rebalancing over both price ranges and time.
As the arbitrage share among V2 trades continues to remain in the same range, we can expect the contribution of V2 as seen in the diagram for Extracted MEV split by Protocol to go down and get replaced by V3.
One of the most popular ways to extract MEV on Uniswap V3 is through Just in Time (JIT) liquidity.
MEV On-chain activity
In terms of trading volume, MEV bots usually contribute 25–30% of total on-chain activity.
Liquidations and Arbitrage
Liquidations on DeFi lending and borrowing platforms mostly happen during sudden market downturns where liquidators pay back loans of users that have fallen under their health factor. As seen in the chart below, liquidations usually occur during extreme market downturns, unlike arbitrage opportunities that can be detected regularly.
Proof of Work and MEV
Additional mining nodes are added to increase the computing power of miners, resulting in an increased probability to create the next block on the blockchain and earn extra profits.
MEV is a way of life for miners on the Ethereum Proof of Work blockchain. If you want to survive among other miners, you need to continue adding more computing power by extracting value from the transactions in the mempool. Miners earning greater profits will eventually crowd out other miners who do not have higher computing power and are unable to increase it because they do not engage in MEV.
Drawbacks
Not only does MEV lead to a delay in the validation of legitimate transactions, but it is also done at the expense of other market participants, resulting in an additional rent or invisible tax on these participants. Moreover, miners involved in MEV add extra transactions to the blockchain, reducing the capacity of the entire blockchain.
Some strategies like sandwich trading or frontrunning bots are clearly beneficial only for the searchers and miners, giving a bad user experience and high slippage to the users involved in the trade.
Permissionless blockchains are useful in cases of high counterparty risk and for greater transparency but that certainly comes at a cost incurred on the users, adding to network congestion, high gas fees and the risk of the integrity of the Ethereum blockchain.
Benefits of MEV?
So far we’ve mentioned the disadvantages that MEV brings to users, how that affects blockchain efficiency and the negative implications to users who get front-run by these miners.
Despite that, there are still a few notable benefits for users. DEX arbitrage involves searchers creating transactions to eliminate any arbitrage opportunities for the users, ensuring users get the best prices for the tokens.
For example, Just-In-Time Liquidity (JIT) is an MEV strategy commonly used in the concentrated pool of Uniswap V3. These bots add liquidity right before the trade and remove it right after it is done.
The competition continues to grow as more people learn about JIT technique. This can be seen from the rising cost incurred by JIT, although the costs are well compensated by the rising profits from the strategy.
Moreover, liquidations on lending protocols rely on speedy liquidations which are possible when rational searchers enter the space to make the protocols running on Ethereum more efficient and robust for the users. Bots competing to liquidate positions on lending platforms also help to keep prices optimised. Decentralization in the system increases as more bots continue to participate in it.
Now that we know about the drawbacks and benefits of MEV on Ethereum’s PoW blockchain, it is important we also understand how moving to Proof of Stake will impact the negative externalities that MEV brings to the users.
Proof of Stake and MEV
As we transition from Proof of Work to Proof of Stake via The Merge, validators will replace the miners and will be responsible for validating transactions and adding them to the blockchain. There will still be ways to extract MEV, which some researchers believe to be greater than what is currently available on the PoW blockchain.
The Beacon Chain processes transactions over a period of time called an “epoch,” which is divided into slots for nestling transactions. Epochs run about 6.4 minutes long with each epoch having 32 slots. Block proposers are given their positions ahead of time. The searchers would therefore have a longer time to find profitable trades, given the heads-up block, proposers have compared to the current PoW blockchain. So, it’s possible the race to outbid other traders becomes more crowded in the PoS Ethereum blockchain
Additionally, dominant validators on PoS will have a significant stake on the blockchain, giving them a higher probability of validating the next block. As the dominant validator continues to earn more money from MEV activities, they will be able to stake more tokens and thus become more powerful in the network.
Another way to become such a leader among PoS nodes would be by collaborating geographically to detect transactions quicker, thus increasing the chances of validating transactions.
Advantages of MEV on Ethereum 2.0
Despite validators receiving high MEV leading to more centralization on the blockchain, we believe high validator incomes will likely attract more users to stake their ETH and become validators. In addition to the existing advantages of MEV on Ethereum, the more active validators there are on Ethereum, the greater the overall security of the network.
What Do The Institutional Authorities Think About MEV?
The recent research paper by the Bank for International Settlements on MEV, considers it to be an illegal market manipulation method similar to front-running and insider trading in the traditional markets.
While regulated intermediaries in TradFi must process trades based on the sequence in the order they are received, miners have no obligation to process the trades based on the timing and can therefore validate any transactions in the mempool.
Despite tracking down the pseudo-anonymous accounts involved in such “attacks” to users, the identities of such attackers are sometimes not known making it difficult to transfer the existing insider trading regulations directly to MEV. Moreover, regulations also vary over jurisdictions and the decentralized nature of Ethereum would make it difficult to access the legitimacy of an exploit. Additionally, there is no information bias when it comes to adding transactions to the blockchain as all miners have access to the mempool.
Read the full paper here:
https://www.bis.org/publ/bisbull58.pdf
Conclusion
Some people believe that MEV is here to stay and the only way out is to design and incorporate MEV minimisation features into the protocols. Flashbots, a leading research and development organization is building tools to democratize and make MEV more transparent by offering services like Frontrunning as a Service (FaaS) to miners and MEV extractors.
While this blog covers MEV on Ethereum, there are a lot of arbitrage opportunities alongside other long tail strategies to capture MEV on blockchains like Solana. In one shape or form, we believe MEV will be around for a while and is an area we’ll be watching closely to see how it develops in case of any opportunities.
Further Readings
Here is a Twitter thread on several MEV-related threads since June 2021.
Disclaimer
The information provided in this article is provided for informational purposes only and does not constitute, and should not be construed as, investment advice, or a recommendation to buy, sell, or otherwise transact in any investment, including any products or services, or an invitation, offer, or solicitation to engage in any investment activity. You alone are responsible for determining whether any investment, investment strategy, or related transaction is appropriate for you based on your personal investment objectives, financial circumstances, and risk tolerance. In addition, nothing in this article shall, or is intended to, constitute financial, legal, accounting, or tax advice. We recommend that you seek independent advice if you are in any doubt.
