MEV Track Overview Have we underestimated its importance?

MEV Track Underestimated Importance?

Author: Yilan

1. Understanding MEV

When Ethereum was still using the PoW mechanism, MEV stood for “Miner Extractable Value”. Under the PoS mechanism, miners have been replaced by validators, and MEV represents the “Maximum Extractable Value”. Unlike in PoW, where a few opaque mining pool operators control transaction ordering and benefit from it, in PoS, the arbitrage rights for transaction ordering within a block are open to anyone, allowing them to participate in the open market for block space arbitrage by playing different roles. GP Dan from LianGuairadigm classifies MEV into EIP-1559 burn, hedging, rebalance loss, and price changes before and after transactions. To break down the understanding of this obscure term MEV, any portion/all value captured through transaction ordering privilege on-chain can be attributed to a certain type of MEV. Therefore, arbitrage behavior on-chain is sometimes collectively referred to as MEV, which is also seen as a byproduct and permissionless incentive measure in the blockchain. Users can extract it based on a first-come, first-served basis.

For example, let’s assume User A sells 100 ETH in an AMM. Due to the AMM algorithm mechanism, each unit of assets sold will lower the price slightly. If a large amount of a certain asset is sold, the price of that asset will be lower than the current market price, resulting in slippage. MEV searchers will buy ETH at the new price after discovering such a transaction and sell it at the market price to complete the arbitrage. In this example, for the transaction initiated by the MEV searcher to successfully complete the arbitrage, it needs to be the first transaction after User A’s transaction. Therefore, it can be seen that there is fierce competition among MEV searchers, and how to become the first transaction before and after a certain transaction usually depends on the priority fee paid to be included in the block first. MEV searchers participate in the gas fee auction market to incentivize miners to promptly include their transactions, resulting in intense competition and high gas costs.

A more traditional explanation is that on the Ethereum blockchain, all new transactions must first wait in the public memory pool (or “mempool”) before being added to a block and added to the blockchain. In the past PoW model, miners decided which transactions to include in a block and in what order. They simply chose transactions with the highest transaction fees and didn’t care about the order of transactions. However, in the vast transaction ecosystem brought about by Ethereum, MEV searchers quickly realized that they could profit by rearranging transactions, reviewing transactions, or creating new transactions based on transactions in the mempool. These profits are MEV. Although searchers are the initiators of MEV, usually more profits are allocated to other participants in the MEV value transmission chain, such as validators, rather than the searchers themselves.

• SEC is expected to give the green light to Ethereum futures ETF expected to be listed as early as October, with a total of 16 applications pending approval.
• Wood Sister’s Long Push Raising interest rates by the central bank is a more important goal than controlling inflation – bursting the Chinese bubble
• Full text of the speech by Hong Kong Chief Executive Carrie Lam at the 2023 Summit on Innovative Technology and Art Development

From the perspective of user and ecosystem sustainability, MEV activities can be roughly divided into two types: arbitrage activities that help price discovery, beneficial MEV such as liquidations, and simple front-running transactions, or more complex sandwich attacks (inserting two new orders between a legitimate buy order, buying the target token at a higher price and selling). These detrimental MEV activities such as front-running and sandwich attacks can lead to regular DEX traders getting worse prices.

2. Overview of the MEV Track

1. Track Characteristics

The MEV track belongs to the underlying basic track and is strongly related to all tracks related to transactions within the blockchain space. It has characteristics such as high income effect, more complex and advantageous for income acquisition with more transaction scenarios, and relatively low risk. It grows together with the expansion of the entire market’s multi-L1 ecosystem.

2. Track Development

(1) Solving the MEV problem is an important part of the Ethereum roadmap. On November 5th last year, Vitalik Buterin, co-founder of Ethereum (V God), released an updated version of the Ethereum development roadmap, which included three major changes, including adding a new phase to the roadmap called “The Scourge” to ensure reliable and fair neutral transactions and solve the MEV problem. This means that protocols that solve the centralization problem of MEV will receive attention, and the attention to this track will gradually increase.

(2) The future development of MEV should focus on cross-chain MEV acquisition, minimizing value loss, minimizing potential negative impacts of MEV on protocol real users, and ensuring fair distribution among participants.

3. Track Scale

The revenue scale of this track is almost synchronous with the trading volume of the cryptocurrency market. Two main factors affect the scale of MEV: the arbitrage frequency has a positive correlation with price fluctuations, and the arbitrage volume has a positive correlation with the total trading volume.

Looking at the revenue from Flashbots, the total gross extraction profit is 713.95 million, which is considered good MEV as it has a positive impact on price discovery and the completion of core functions in DeFi as well as trading volume in DEX. The revenue from sandwich attacks is 1206.11 million, which is considered unfavorable MEV. Most MEV-protected DEXs hope to control and democratize this part of the profit.

If we use Uniswap, Pancakeswap, and Sushi, which are ranked in the top three in terms of cumulative fee revenue, as anchors, the cumulative fees of the three DEXs are 5.21 billion (3.24 + 1.2 + 0.77 billion). Roughly estimated, the MEV revenue obtained through Flashbots accounts for 37%. In fact, besides major DEXs, significant MEV income will also be generated on other dApps on Ethereum, alt L1s, and L2s. To estimate the scale of various sub-tracks formed by the transmission of these fees throughout the value chain, it is necessary to analyze how MEV profits are distributed among different participants.

According to Eigenphi’s data, in January and February 2023, MEV searchers obtained $48.3 million from transactions of all users through wallets and RPC, of which $34.7 million flowed to builders. The builders then sent $30.3 million to validators.

Profit distribution: Searchers – $7.3 million (17.4%); Builders – $4.4 million (10.5%); Validators – $30.3 million (72.1%). (The specific roles and functions of these participants will be introduced later in the text.) It is not difficult to see that the majority of the profit (72%) is captured by downstream validators.

In the $48.3 million, $6.3 million was used for the burning of EIP 1559. The priority fees for regular transactions transferred from wallets and RPC to builders and then to validators amounted to $32.554 million. The regular transactions from wallets and RPC burned $227.2 million for EIP 1559.

In the bull market of 2021, the overall revenue ceiling was $476 million. Calculated with a lower 10x PS, the overall track size is nearly $5 billion. The track size of each segmented track can be estimated based on the proportion, with Searchers exceeding $1 billion and Validators exceeding $3.5 billion. This is just a rough estimate.

However, the robots that profit from on-chain transactions may still bear the cost of many failed transactions and the impact of other off-chain hedging costs, which are not included in the calculation. And this is only the income calculation for direct participants, without calculating the market for indirect participants. In fact, the scale of the entire track will far exceed the above numbers.

4. Two perspectives on the MEV track pattern

(1) Value chain

• Upstream (RPC provider): Upstream refers to service providers that provide on-chain transaction information and data, usually Ethereum node operators or RPC (Remote Procedure Call) service providers. These service providers provide necessary data interfaces to middle and downstream participants, enabling them to obtain information about transactions and blocks, thereby better participating in MEV-related activities. For example, Uniswap will send transactions initiated by users (TX) through RPC (Remote Procedure Call), and these transactions will enter the Ethereum mempool.

• Midstream (tools and infrastructure): Midstream includes various tools, platforms, and infrastructure that help connect upstream and downstream participants, thereby realizing the distribution of MEV value. These midstream tools may include search engines, transaction builders, transaction relays, etc., which enable searchers, builders, block producers, etc. to discover, execute, and allocate MEV opportunities more effectively.

• Downstream (MEV profit recipients): Downstream covers participants who truly benefit from MEV value, including validators and other individuals or entities who actually gain MEV profits. Validators are nodes that participate in block validation in Proof of Stake (PoS) networks. They can receive rewards from transaction fees and the base interest of the network, which are facilitated by midstream and upstream activities. Downstream validators include cryptocurrency exchanges (CEX), liquidity staking platforms, institutional stakers, and individual stakers, etc.

(2) Direct participants and indirect participants

MEV value chain transmission process

Direct participants include searchers, builders, relayers, and block producers (validators). These types of participants together form the supply chain pattern of MEV. Tools that provide better services for these direct participants, such as infrastructure aimed at addressing MEV-related challenges, including Flashbots, which was valued at $1 billion and recently raised $60 million in funding this month to develop the SUAVE platform.

SUAVE (Single Unified Auction for Value Expression) is an infrastructure designed to address MEV-related challenges, with the vision of becoming a shared ordering layer for different chains. SUAVE focuses on separating the roles of the mempool and block generation from existing blockchains, creating an independent network (ordering layer) that can serve as a plug-and-play mempool and decentralized block builder for any blockchain, acting as the mempool and builder for other chains. SUAVE’s main goal is to provide a more decentralized and fair ecosystem for participants involved in MEV, such as users, block builders, and validators. By separating the mempool and builder of all chains from other roles and implementing specialized management, overall chain efficiency is improved, achieving a win-win situation where the blockchain itself becomes more decentralized, validator income increases, searchers/builders can set preferences and have greater potential income, and users can conduct private transactions at the lowest cost.

· Searchers write code, usually supported by proprietary complex algorithms, to identify MEV opportunities in the mempool. They are responsible for monitoring the public transaction pool and Flashbots’ private transaction pool. They compete to submit response “packets” to builders and provide a gas bid, expressing the maximum cost they are willing to pay (priority fee).

· Block Builders are professional providers that compete in real-time markets to perform block construction on behalf of validators. Any user who downloads MEV-Boost can become a Block Builder. Builders accept transactions from searchers and further select profitable blocks from them, which are then sent to relays through MEV-Boost.

· Relays act as intermediaries between block builders and block proposers, allowing validators to provide their block space to block builders. Some relays include transactions of ETH that have been passed through the Tornado Cash protocol in the past, while others exclude or “scrutinize” these transactions. MEV relays are controversial due to scrutiny issues. In August 2022, Tornado Cash was blacklisted by the Office of Foreign Assets Control (OFAC) of the U.S. Department of the Treasury, making it illegal for U.S. citizens, residents, and companies to receive or send funds through the protocol. Since then, validators must carefully consider the relays they use to capture MEV income and decide whether to exclude relays that are considered “OFAC compliant”. Given the high number of Ethereum nodes in the United States, many validators based in the U.S. are likely to choose to comply with regulatory scrutiny and avoid non-compliance risks. However, this goes against the principle of censorship resistance. Flashbots’ own relays were the first MEV-Boost relays and chose to scrutinize non-compliant transactions, which explains their initial dominance in OFAC-compliant block production on Ethereum. With more relays becoming available, including non-scrutinizing relays, this trend has reversed, and now less than half of the blocks are OFAC compliant. It can be seen that Flashbots’ relay market share has declined and is currently at 23%.

MEV Boost Relay Market Share

· Block Producers/Validators are entities responsible for validating and proposing the addition of blocks to the PoS-based blockchain. They are often the biggest beneficiaries of MEV revenue. Any user under PoS can stake 32 ETH to become a Validator. Currently, Lido is the largest Validator. With the use of MEV-Boost, Validators can select the most profitable block from proposals made by multiple relayers and collect a priority fee. Subsequently, one random Validator is chosen as the Proposer to submit the final transaction (block).

Indirect Participants include almost all underlying L1, L2, and Application-layer projects that generate transactions. The Application layer is further divided into DEX, Lending, and LSD (MEV activities throughout the entire DeFi ecosystem, including increasing transaction fees, assisting with liquidation, and helping Validators improve the APY of the execution layer). It then extends to protocols that help users avoid MEV in specific transaction scenarios (including tool providers and beneficiary protocols) such as Unibot and TGbot protocols.

Leading Projects for Different Participants

• Lido

MEV is still significant for the Ethereum economy, accounting for over 15% of all Ethereum transactions and increasing the rewards rate for stakers and Validators by 25%. Lido, as the largest beneficiary downstream Validator, accounts for 31.7% of the overall revenue among Validators, amounting to 19.86 million (data from January to February of this year). Taking the APR of the execution layer of Lido DAO as an example, MEV revenue is the main source, accounting for approximately one-third of the total stETH revenue. When on-chain transaction activity is high, this percentage can even reach nearly 70%. Therefore, it is speculated that when the bull market arrives, MEV revenue will still account for 70% of the total revenue from staking, indicating a high correlation between the development of the MEV and LSD tracks.

• Uniswap

MEV Extraction by Different DEX Protocols

Profits from MEV transactions on Uniswap amount to 252 million. In 2022 alone, arbitrage bots extracted at least 85 million USD from market price asymmetry involving Uniswap V3 liquidity pools. Sandwich bots extracted at least 47 million USD from Uniswap V3 exchange users. JIT bots extracted 6 million USD from Uniswap V3 exchange fees.

The total value extracted from these three types exceeds 25% of the supply-side revenue, which amounts to 540 million USD.

For real users of Uniswap, the future UniswapX will significantly enhance the benefits for swappers by internalizing MEV revenue. The aggregator and RFQ off-chain order matching mechanism of UniswapX will be a significant improvement in preventing MEV (although sacrificing decentralization). For MEV cross-chain extraction, the cross-chain technology planned by UniswapX is a critical infrastructure.

Unibot

The current market value of the TG Bot track is less than 200 million USD, with Unibot occupying approximately 75% of the market share.

Considering Telegram’s user base of 800 million, Unibot attempts to open a massive traffic entrance through functional integration. Although the robot’s functionality is still in the early stages, providing one-stop trading within the traffic pool is a distinct method of acquiring users compared to most DeFi applications, although the majority of transactions still occur on Uniswap.

Currently, the number of daily active users of Unibot has increased from around 400 to a peak of 1700 in the two weeks of July. Objectively speaking, there is still a lot of room for growth in this user group. However, this user group is relatively special and usually remains active during the meme market trend. The overall market value is still small, but the business logic is sound. The token has a reasonable dividend mechanism (40% revenue sharing to holders) and a high growth ceiling. In the long run, only users who are not price-sensitive will use Unibot, compared to a 5% higher tax when trading directly on Uniswap. These protocols also have obvious shortcomings. Due to different settings of the robots, users are usually allowed to create dedicated wallets or connect existing wallets. In both cases, the robot will have access to the private key, which may add an extra layer of risk for users.

• Valuation

• Unibot peak Vol/FDV = 12mln/182mln= 0.06

• Uniswap: Vol/FDV = 429mln/6193mln=0.069

• Velo: Vol/FDV 7.5mln/100mln=0.075

From the Vol/FDV indicator, the market has pushed the price of Unibot to a reasonable valuation range. However, as the meme hype subsides, the trading volume of Unibot will also decrease significantly.

In addition to the Ethereum ecosystem, there are also MEV opportunities in other ecosystems. Furthermore, more complex cross-chain trading scenarios in the future will significantly amplify MEV activities.

III. Dynamic Balance between MEV and DEX Ecosystem

There is a positive correlation between MEV trading volume and total trading volume. Eigenphi data shows that the correlation coefficient between trading volume (excluding arbitrage trading volume) and arbitrage trading volume is 0.6, and the correlation coefficient between trading volume (excluding sandwich trading volume) and sandwich trading volume is 0.62. Therefore, the larger the total trading volume, the larger the MEV trading volume. More and more DEXs are increasing their total locked value (TVL) across multiple chains, and liquidity pools of the same assets will be formed on multiple channels, but their trading volumes and depths vary, creating new opportunities for trading and MEV.

Other factors that may affect MEV activities include the level of gas fees (lower fees potentially lead to higher profits, but searchers may still raise the gas for a larger transaction, affecting the entire network) and market volatility (higher market volatility creates more opportunities for sandwich arbitrage).

AMM is where most MEV is extracted. With the introduction of concentrated liquidity ranges in Uni V3, traders can trade within smaller price ranges, reducing some price differences and thus reducing the profitability of certain MEV activities. Additionally, Uni V3 adopts a more refined price-setting mechanism, resulting in smaller slippage compared to previous versions. In theory, this reduces some potential MEV profit opportunities and helps to reduce some MEV activities. In simple terms, as liquidity becomes deeper at a certain price range and users set prices more finely, the slippage decreases, and there is a significant decline in the profit potential that MEV can arbitrage.

Further emerging MEV-resistant DEXs aim to protect ordinary users through the following mechanisms:

(1) Order transparency and predictability – DEXs can publicly disclose the details of orders before they are submitted, using mechanisms such as auctions. They can also use off-chain matching mechanisms similar to order books to reduce the opportunity for front-running attacks. By disclosing information in advance, traders can better predict market behavior, thereby reducing the probability of attacks.

(2) Time-locked transactions – Implementing time locks restricts transactions from being executed until after a specific block. This can reduce the impact of attacks such as flash loans, as attackers cannot execute multiple transactions within the same block.

(3) Batch transactions – DEXs can allow traders to submit multiple transactions and process them as a batch. This can increase transaction privacy and reduce the ability of attackers to analyze transactions.

So how does this MEV prevention practice affect trading volume? For MEV-resistant DEXs, this portion of the benefits is transferred to their users. Although the reduction of sandwich attacks or the transformation into fees not directly generated may be the reason for the decrease in trading volume, in reality, maintaining a good trading environment is beneficial for the sustainable development of any trading system.

MEV also has different impacts on traders, liquidity providers, and miners. For traders, MEV, especially adverse MEV, increases transaction costs. Traders need to pay higher transaction fees to ensure that their transactions are prioritized and confirmed on the blockchain. This increases the cost for traders, especially during high network congestion.

Next is the issue of information asymmetry. MEV allows certain stakeholders to exploit their control over transaction sequencing to gain market information and obtain unfair advantages. This exposes other traders to the risk of information asymmetry.

For liquidity providers (LPs), providing liquidity becomes riskier. LPs may face the risk of sandwich attacks, where the liquidity they provide can be exploited by other traders during transactions, resulting in losses. Additionally, LPs also face the issue of compromised cost-effectiveness. They need to consider higher gas fees and risks to balance their profits and risks.

For miners/validators, MEV may lead them to optimize their mining strategies to earn more transaction fees and rewards. However, this also means increased competition, with miners/validators competing for MEV, resulting in gas price hikes and network congestion.

IV. Solutions to prevent adverse MEV

There are solutions to prevent adverse MEV at the consensus layer, execution layer, app layer, L2, and MEV tools.

At the consensus layer, Ethereum’s “The Scourge” phase focuses on ensuring reliable and fair neutral transactions and addressing the MEV problem. At the transaction execution layer, peer-to-peer transactions and gasless transactions can prevent adverse MEV. Peer-to-peer transactions mean that transactions occur directly between the parties involved, reducing the possibility of intermediaries’ intervention and malicious behavior. Gasless transactions and separation from the mempool can reduce the opportunity for malicious actors to gain an advantage by increasing gas fees. In addition, there have been innovative attempts that provide ideas for preventing adverse MEV. For example, EigenLayer introduces MEV-boost and partial block auction mechanisms in certain blocks, providing new ideas and methods for modular MEV stack design.

In Layer 2, the Taiko project adopts a very different approach – outsourcing block creation to L1, providing a potential solution to the complexity of L2 MEV by leveraging the capabilities of the Ethereum base layer.

At the app layer, through Dex aggregator (in fact, the work done by Dex aggregator in preventing MEV has not been emphasized, as it reduces the impact of slippage on spot prices by placing orders on different routing channels, thereby preventing unfavorable MEV from finding trading opportunities), backrunning service, and off-chain matching orders, auctions, or batch processing orders (the uniform pricing within batch processing orders fundamentally solves the problem of MEV sandwiching. Since the transaction interface directly matches between peers, there is no issue of transaction order), the harm of MEV to users is minimized.

In terms of MEV tools, Flashbots aims to mitigate the negative impact of MEV on the entire ecosystem, such as on-chain congestion. Flashbots has launched several products, including Flashbots Auction (including Flashbots Relay), the Flashbots Protect RPC, MEV-Inspect, MEV-Explore, and MEV-Boost. The upcoming SUAVE, as a sorting layer for different chains, will focus on user preferences and optimize transaction paths to create the most efficient route based on searcher’s search preferences.

Conclusion

In terms of the importance of the race, MEV is a byproduct of block generation and can even be said to be the future of the crypto world. The strong cash flow characteristics ensure that the roles of Searcher, Builder, Relayer, and Validator, as well as the tools and products that provide services and optimizations around these roles, still have a strong income effect. However, since not many Searchers and Validators who truly capture MEV income have turned it into protocol issuance, there are fewer secondary investment opportunities. However, some application-level applications will gain additional edge by tapping into the MEV race, and tool projects also have good investment opportunities in the primary market. However, these types of tool projects need to consider how to capture value for their own protocols rather than just enhancing the profitability of existing participants.

Although MEV has had a certain negative impact on users, its reasonable use and existence can also bring many positive factors. For example, arbitrage traders ensure the consistency of token pricing for various AMMs, meet the anchoring mechanism of stablecoins, ensure the smooth liquidation of DeFi loans, and maintain incentives for block proposers to increase blockchain security (by providing higher execution layer rewards) and so on.

In general, the development direction of the MEV race focuses on several key areas: cross-chain MEV acquisition, minimizing value loss, mitigating potential negative impact of MEV on protocol real users, democratizing revenue, promoting decentralization of sorters, and ensuring fair distribution among participants. Currently, we can observe that UniswapX’s cross-chain technology plays a critical role in achieving MEV cross-chain acquisition. Overall, the value of the MEV market is related to more complex trading scenarios and market fluctuations in the future, which will bring more opportunities for traders. To mitigate the potential negative impact of MEV on protocol real users, it can be alleviated by adopting fair distribution and privacy protection at the consensus layer and implementing mechanisms such as off-chain order matching and reducing slippage of spot prices at the protocol layer. In addition, the stackization and decentralization of MEV participants are also crucial components in the Ethereum roadmap, which will help build a more robust and secure MEV ecosystem.

There are still many areas worth exploring in democratizing MEV profits. For decentralized exchanges (DEX) that aim to prevent MEV extraction attacks, a portion of the profits initially obtained by the front-runners are transferred to the trading users. While anti-MEV designs may reduce or alter front-running behaviors, potentially leading to a decrease in transaction volume influenced by unfavorable MEV, maintaining a healthy trading environment is crucial for the sustainable development of any trading system. Gradually, positive MEV profits contribute to the overall health of the on-chain transaction ecosystem.

A fair market competition environment provides fertile soil for innovation, while more efficient benefit distribution mechanisms and decentralized architectures are the cornerstones of achieving this goal. The influence of front-runners and block-building technologies on the entire trading environment depends on how people utilize them.

We will continue to update Blocking; if you have any questions or suggestions, please contact us!