- Maximal Extraction Value (MEV) is often talked about highly due to the underlying power structure in the blockchain’s code.
- This causes information asymmetries which allows miners and searchers to utilize arbitrage opportunities across DEXs.
In centralized exchanges, some traders use the practice of frontrunning, where they leaked information about some critical market news before other traders, and based on which they placed trades and made profits. This is considered illegal and firms caught doing this were severely penalised.
Another way of making profits was using the different reaction exchanges to the market news, which created price differences of the same stock across two different exchanges. Traders used these arbitrage opportunities to generate profits. Firms relied on bots to find such arbitrage opportunities and automatically execute the trade.
With the launch of blockchain networks and the Ethereum public chain, smart contracts and decentralized exchanges came into the scene. The order book in traditional exchanges was maintained by an exchange operator whose duty was to match buyers and sellers to complete the transaction.
In some DEXs, the order book was maintained by smart contracts, and in some, the order book concept was replaced by Automated Market Makers (AMM), which held the asset and provided liquidity. These DEXs were made to overcome the limitations and challenges of CEX.
The Background to Understanding MEV
Public blockchains like Bitcoin and Ethereum rely on Proof-of-Work consensus to allow miners cryptographically link a new block to the existing chain. The network is open and all the transactions are visible to everyone.
Suppose a person gets caught in an arbitrage opportunity and wants to execute a transaction quickly to gain profit. Now they submit the transaction with some gas fees for a miner to execute. The pending transactions are all stacked up in mempools, an off-chain space.
An interesting case here is regarding the power structure and information asymmetries. Similar to CEX, where big firms and veteran traders could get news early and perform frontrunning, the transactions in mempool are visible to the experienced miners first than other users. After viewing an arbitrage opportunity from some user in the mempool, they can execute their transaction with the same opportunity before the users and make a profit.
This comes from the fact that miners can choose transactions and place them in any order they wish in the block. They chose the ones with higher gas fees and place their transaction before the honest users and make profits. This extra stream of revenue is called Miner Extractable Value (MEV).
MEV was first identified by a long-time algorithmic trader and analyst coder who went by the name Pmcgoohan. He was excited when he first learned about Ethereum but soon found some critical flaws when he read its pre-genesis draft. He learned that miners had full control in including and ordering transactions.
However, his warning was unheard and Ethereum faced these issues with the end user being most exploited. A group of researchers in 2019, led by Philip Dian, published a paper Flash Boys 2.0, which confirmed that MEV was not just in theory but also in practice.
MEV After The Merge
After The Merge, Ethereum adopted Proof-of-Stake consensus and replaced miners with validators for confirming the transactions. Here, arbitrage traders and bots, known as “the searchers”, are used to find such arbitrage opportunities and capture them.
These bots often engaged in Priority Gas Auctions (PGAs), where two bots competed against each other on the gas price rapidly and finally the validator chose the transaction with higher gas fees.
The validator may not directly be benefitted from the arbitrage opportunity but earns a hefty sum in terms of gas fees. So, many searchers are competing to exploit the same arbitrage opportunity and theoretically, the searchers are willing to pay even 100% of their MEV revenue.
The term MEV is now called maximable extractable value and although associated with Ethereum, it is not a Proof-of-Work or Ethereum-exclusive issue.
Final Thoughts
Some people believe that MEV is unavoidable while others believe that the MEV issue can be solved. Research groups have developed flashbots, which allow searchers to provide validators with transactions without broadcasting it to mempool and thus preventing frontrunning. MEV poses measurable and concrete consensus layer risks and serious threat to Ethereum today.
