What is MEV and is it here to stay?

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What is MEV?

What is MEV, the enigmatic term that stands for maximal extractable value? Originally an abbreviation for “miner extractable value”, MEV refers to the additional value that can be extracted from block production on top of the regular block rewards and transaction fees. This opportunity to maximize profits stems from the ability to include, exclude and order transactions in a block – an ability that has historically been associated with miners in Proof-of-Work blockchain networks. However, the growing prominence of Proof-of-Stake has seen validators taking on those responsibilities, which has imbued the MEV term with a new meaning. This became particularly evident after Ethereum’s recent shift from PoW to PoS, as the term was changed to reflect the rise of the validator role on Ethereum.

While the MEV phenomenon is not exclusive to Ethereum, it’s certainly most prevalent there. This is because Ethereum is by far the biggest platform for decentralized finance and smart contracts. 

What is MEV and how does it work?

As mentioned above, MEV occurs as a natural consequence of the way transactions are added to a blockchain ledger. In short, all transactions are first submitted to a ‘mempool’ that is then scoured by block producers (miners and validators in PoW and PoS networks, respectively) who decide what transactions to include in a block. And because there are no rules that need to be followed during this process, financial incentive is the only factor that can influence the ordering of transactions. In other words, users that are willing to pay higher fees are likely to get their transactions processed much faster. This can be seen as the simplest form of MEV and it has been around since the very beginning of the blockchain revolution.

Following the advent of Ethereum and the rise of smart contract-powered DeFi, MEV strategies have become much more elaborate. Meanwhile, block producers are no longer the only players in the MEV process. Lately, the role of ‘searchers’ has become increasingly prominent.

Searchers’ main goal is to find profitable opportunities like lucrative DeFi trades. To that end, they utilize sophisticated algorithms for analyzing blockchain data and use bots that automatically submit transactions to the network to capitalize on the opportunities identified by the algorithms. To increase the chance of getting their transaction included in a block, searchers are usually willing to pay premium gas/transaction fees, sometimes in excess of 90% of the expected MEV. This is why block producers still get the lion’s share of the profits, even though they may not be active participants in the MEV process.

Common MEV strategies

So what MEV strategies are there? Well, let’s take a closer look at the most popular ones.

DEX arbitrage 

Arbitrage is perhaps the most conventional MEV strategy, as it is used in traditional trading, as well. Put simply, arbitrage is a trading strategy that allows traders to take advantage of the temporary difference in the price of an asset between exchanges. In DEX arbitrage, the assets are cryptocurrencies, whose price often vary from one decentralized exchange to another. To take advantage of this, a trader can buy a crypto asset at a lower price on one decentralized exchange and sell it at a higher price on another DEX. Thanks to blockchain, this can happen in a single atomic transaction allowing for traders to quickly capitalize on lucrative opportunities. This makes DEX arbitrage stand out, as other MEV techniques, for example, front-running, require separate transactions. 

Because it is a well-known and widely employed strategy, DEX arbitrage is also super competitive. For example, several searchers may attempt to capitalize on the same arbitrage opportunity, which could trigger a bidding war, known as ‘gas-price auction’,  leading to higher and higher transaction fees to incentivize block producers. Alternatively, a block producer could decide to copy a searcher’s transaction in an attempt to capture the opportunity themselves.

Front-running

This strategy of copying profitable transactions is known as frontrunning and can be practiced by searchers, as well as block producers. Searchers do this by running frontrunner bots which monitor the mempool for lucrative trades. If the bot finds such a trade, it copies the transaction and offers a higher fee to incentivize block producers to prioritize the copy.

Back-running

This strategy also involves monitoring a mempool for large pending transactions, but this time the goal of the searcher bot is to place a transaction immediately after the target transaction has been executed. In doing so, the searcher seeks to capitalize on the impact the target transaction is expected to have. For example, the searcher bot could  place an opposite trade, seeking to take advantage of the price fluctuations that are bound to occur as a result of the target transaction. Or it could capitalize on a new liquidity pool launch by capturing a large amount of one of the tokens in the new trading pair, thus stoking investor interest and driving prices higher before selling its token holding at a profit.

Sandwich trading

Another well-known MEV strategy, sandwich trading involves placing transactions before and after large orders to benefit from the price changes such orders cause. For example, you can acquire tokens just before a large buy order for the same asset and then sell your holding after the original trade has driven the token price higher.

Liquidations

Lending protocols like Compound and Aave present even more MEV opportunities in the form of liquidations. The way such protocols typically work is by allowing people to borrow crypto against a collateral in another crypto that they have deposited to their lending protocol of choice. A user’s borrowing power depends on the collateral they have deposited. But as crypto prices change, the value of the collateral also fluctuates, in turn impacting the borrowing power. This can lead to a situation where the amount of assets a user has borrowed exceeds their voting power. In such cases, the borrower’s collateral becomes eligible for liquidation and the protocols typically allow for anyone to become a liquidator. Once the collateral is liquidated and the lenders paid off, the borrower usually has to pay a large liquidation fee, some of which goes to the liquidator.

In order to take advantage of these MEV opportunities, searchers use either front-running or back-running techniques to ensure that they get to liquidate the collateral.

The MEV effect

While MEV extraction has really exploded in popularity in the past year or so, the practice is deemed highly controversial by many and this sentiment is not unjustified. This is not to say that MEV does not have a positive side. Arbitrage, for example, is not only quite inoffensive, but it can also contribute to the health of a market by ensuring that traders always receive the most accurate prices for their tokens. Likewise, MEV ensures that collaterals are liquidated in a timely manner. 

However, the negative effects of MEV are also undeniable. On the one hand, strategies like sandwich trading can directly lead to worse prices for traders, damaging the user experience. On the other hand, gas price auctions between front-runners can cause network congestion and raise the gas price for everyone on the network. Other issues can arise when block producers rearrange the order of transactions to capture MEV opportunities. This could lead to larger blockchain reorganization and have implications for the entire network.

Conclusion

As DeFi continues to grow and mature, the appeal of MEV is only going to increase. The sector is just too ripe with MEV opportunities and its reliance on smart contract-driven automation makes exploiting such opportunities through timely-placed transactions a relatively straightforward affair. And we also should not overlook the positive effects of MEV. This is why there is already considerable dev effort dedicated to mitigating the negative effects of strategies like front-running and sandwiching, as well as democratizing the access to MEV revenues. Perhaps, thanks to such projects, MEV would one day become a true force for good in the DeFi space.

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