Maximal Extractable Value (MEV)

Maximal Extractable Value (MEV)

Definition: MEV, or Maximal Extractable Value, is essentially the maximum profit a miner or validator on a blockchain can make by manipulating the order in which transactions are included in a block. Think of it like a hidden tax or a side hustle for those who control the block production process.

Key Takeaway: MEV allows block producers to profit by rearranging, including, or excluding transactions, often at the expense of regular users.

Mechanics

MEV arises from the ability of block producers (miners in Proof-of-Work systems like Bitcoin and validators in Proof-of-Stake systems like Ethereum) to choose which transactions they include in a block, and in what order. This seemingly simple power opens the door to complex strategies for extracting value. There are several common types of MEV strategies:

• Front-Running: This is perhaps the most well-known MEV strategy. It involves a bot or a miner observing a pending transaction in the mempool (the pool of unconfirmed transactions). If the bot sees a large buy order for a specific token, it can place its own buy order before the original transaction is confirmed. The bot then sells the token at a slightly higher price, profiting from the price increase caused by the original large buy order. This is front-running.
• Back-Running: This is the opposite of front-running. A bot waits for a large sell order to execute, and then quickly buys the token after the price has dipped due to the sell order, aiming to profit from the subsequent price recovery.
• Sandwich Attacks: This combines front-running and back-running. A bot places a buy order before a large buy order (front-running) and a sell order after the large buy order (back-running), effectively sandwiching the original trader and profiting from both price movements.
• Arbitrage: This involves exploiting price discrepancies for the same asset across different decentralized exchanges (DEXs). A bot can identify that a token is trading at a lower price on one DEX and a higher price on another. The bot then buys the token on the cheaper DEX and immediately sells it on the more expensive DEX, pocketing the difference. MEV bots can extract arbitrage opportunities from other users by monitoring the transaction mempool and copying the trades, while paying a higher fee to block producers for their transactions to be included rather than the original arbitrage transaction.
• Liquidation: In decentralized lending protocols, when a borrower's collateral falls below a certain threshold, their loan is liquidated. MEV bots can monitor these positions and quickly liquidate them, profiting from the difference between the collateral value and the outstanding debt. The bot pays a higher gas fee to have their liquidation transaction confirmed before other potential liquidators.

MEV extraction is made possible by the fact that miners/validators, by default, prioritize transactions with higher gas fees. This incentivizes MEV searchers to bid up gas prices, creating a sort of auction for transaction inclusion. This can lead to increased gas costs for all users, as well as a more competitive environment for those trying to execute specific trades.

Trading Relevance

MEV has a direct impact on trading in several ways:

• Increased Transaction Costs: MEV bots often bid up gas prices, making all transactions more expensive. This is especially true during periods of high network congestion and high MEV activity.
• Slippage: The price impact of large trades can be exacerbated by MEV. Front-running and sandwich attacks can cause a trader to receive a worse price than they initially expected due to price manipulation.
• Trade Execution Speed: The competition for transaction inclusion can create an environment where speed is paramount. Traders may need to use advanced techniques, such as gas price sniping, to ensure their trades are executed quickly and efficiently.
• Market Manipulation: MEV can be used to manipulate prices, creating artificial volatility and potentially harming less sophisticated traders.

To mitigate the negative effects of MEV, traders can consider the following strategies:

• Using DEX aggregators: These platforms route trades through multiple DEXs, potentially finding the best prices and reducing slippage.
• Setting slippage tolerance: This limits the amount of price slippage a trader is willing to accept.
• Using private transaction relays: These services allow traders to submit transactions directly to miners or validators, bypassing the mempool and reducing the risk of front-running.
• Understanding gas optimization: Being mindful of gas costs and optimizing transactions can help traders avoid paying excessive fees.

Risks

MEV poses several risks to traders and the broader DeFi ecosystem:

• Increased Costs: Higher gas fees and slippage can erode trading profits.
• Unfair Market Conditions: MEV creates an uneven playing field, favoring sophisticated traders and bots over ordinary users.
• Centralization: The pursuit of MEV can lead to the centralization of block production, as larger entities with more resources are better equipped to extract value.
• Network Congestion: MEV-related activities can contribute to network congestion, slowing down transaction processing and increasing costs for all users.

History/Examples

MEV has been a feature of the blockchain space since the early days of decentralized finance. Some notable examples include:

• The Ethereum Network: Ethereum has become a hotbed for MEV activity, with billions of dollars extracted by MEV bots since the rise of DeFi. The introduction of Flashbots, a platform that allows MEV searchers to submit transactions directly to miners, has further fueled MEV activity on Ethereum. Flashbots introduces a separation between block proposers and builders.
• The PancakeSwap Incident: In early 2021, a trader was front-run on PancakeSwap, a decentralized exchange on the Binance Smart Chain. The attacker used a bot to monitor the mempool and execute a trade before the victim's trade, making a profit at the victim's expense.
• The SushiSwap Migration: During the initial migration of liquidity from Uniswap to SushiSwap, MEV bots were able to extract significant profits by front-running and sandwiching transactions related to the migration.

MEV is a complex and evolving area, and the strategies used by MEV searchers are constantly changing. As blockchain technology continues to develop, MEV will remain an important area of development, and will contribute to shaping the blockchain systems of the future.

Fair Sequencing Services (FSS)

Chainlink is developing Fair Sequencing Services (FSS)—a transaction ordering solution using decentralized oracle networks to mitigate the detrimental effects of MEV.