Understanding MEV in Ethereum: Strategies and Future

[00:00:00]Did you know that when you  make a move on Ethereum,   there’s a hidden, high-stakes game playing out?

[00:00:05]And what if I told you this game could be the  secret to cheaper, more efficient transactions or,   sometimes, the cause behind those  unexpected high fees and delays?

[00:00:14]Meet MEV, a concept that’s  reshaping the Ethereum we know.

[00:00:19]But who drives this game? What roles do  searchers, builders and proposers play?   How do Flashbots come into the picture, and  what's their mission? And does MEV provide   extra incentives for validators or create an  existential threat to the decentralisation   of the whole network? You’ll find answers  to these questions and more in this video.

[00:00:38]And we promise you, by the end of this video,  Ethereum will never look the same to you again.

[00:00:44]Before we dive in, if you want to learn more  about decentralised finance and the technology   behind it, make sure you subscribe to my channel,  hit the bell icon and enable all notifications.

[00:00:54]To define the concept of MEV, let's  first look at the simplified model   that many people believe represents  how Ethereum transactions work.

[00:01:02]At its core, when you initiate a transaction, it  first enters the 'mempool'. Think of the 'mempool'   as a waiting room for pending transactions.  When building a new block, the block proposer   can choose and prioritise transactions from  the mempool based on their transaction fees.

[00:01:17]However, MEV introduces a unique twist.  Block proposers can not only choose which   transactions to include and their order  within a block but also add their own.   The sequence of these transactions can  occasionally yield substantial profits.

[00:01:32]Imagine this scenario: Alice purchases a large  amount of a specific token. Following her,   Bob opts to sell the same token. If Bob's  transaction is processed after Alice's,   he capitalises on a better sale price due  to the increased demand Alice's purchase   creates. Spotting such opportunities,  a block proposer might rearrange the   order of transactions to benefit and  take a 'cut'. The proposer can achieve   this by inserting its own buy transaction just  before Alice’s transaction and placing a sell   transaction after Alice’s transaction  and right before Bob’s transaction.  In this rather nasty example, the block proposer  essentially frontruns Alice’s transaction,   benefiting from the price movement  they can predict and influence.

[00:02:18]This additional profit, resulting from  altering the transaction sequence,   is termed MEV, which stands  for Maximal Extractable Value.

[00:02:28]Understanding MEV is extremely important as   it creates various challenges  for a network like Ethereum.

[00:02:34]From an end-user perspective, MEV  can manifest in different ways,   including affecting trade  executions. For instance,   if you receive fewer tokens from a DEX trade than  initially anticipated, it could be due to MEV.

[00:02:47]From the network's standpoint, MEV risks pushing a  decentralised system toward centralisation. Under   proof-of-work, mining pools were incentivised to  become highly specialised, potentially leading   to centralization among them. This draws  uncomfortable parallels with traditional   finance, moving away from the aspirational,  transparent, decentralized finance model.

[00:03:09]Outside of transaction ordering, block proposers  can also decide to include or exclude a particular   transaction, either by prioritising one offering  higher fees or censoring specific transactions.

[00:03:21]In general, MEV can be extracted  and classified in a number of ways.

[00:03:26]Let’s visit the realm of MEV  with these common strategies: Frontrunning: Proposers spot a pending transaction  in the mempool that can shift the market and jump   right ahead to benefit from the price change. Backrunning: Opposite of frontrunning,   proposers position their transaction  right after a significant one,   often exploiting potential price discrepancies  or arbitrage opportunities between exchanges.  Sandwich Attacks: A combination of frontrunning  and backrunning. Proposers see a large order,   place their own order ahead of it (frontrun)  and then place another order after it (backrun).   Essentially, they "sandwich" the user's  transaction. That is what happened in   our previous Alice and Bob example. Censorship: A proposer could censor   transactions to benefit from MEV elsewhere,  demand higher fees or manipulate oracles.  Generalised frontrunning: A proposer could  execute any profitable transaction for themselves,   even without fully understanding the  transaction content. This strategy   is possible by simulating transaction  execution and determining if the caller   of a given smart contract method ends up  with more funds than before the execution.

[00:04:36]MEV strategies can sometimes be  categorized as toxic or non-toxic.

[00:04:41]Toxic MEV is the type of MEV that has negative  effects on the blockchain ecosystem and its users.   Examples of toxic MEV include: Front-Running,  Sandwich Attacks, Censorship With front-running and sandwich attacks,  users end up having worse execution of their   transactions. With censorship, the decentralised  and stable nature of the ecosystem is at risk.

[00:05:03]Non-toxic MEV, on the other hand,  refers to the forms of MEV that   don't negatively impact users or  the integrity of the blockchain.

[00:05:12]Back-running serves as a prime  example of this. However,   it's worth noting that the classification  of MEV as 'non-toxic' can be subjective.

[00:05:20]As an example, while arbitrage and  back-running lead to more efficient prices,   they also lead to losses for liquidity providers.

[00:05:28]As we can see, it’s helpful to classify MEV as  it allows us to understand its impact better.

[00:05:34]Before we jump into the current MEV landscape,   let’s look at how we got here and  how the MEV space evolved over time.

[00:05:41]Though MEV has been an intrinsic part of Ethereum  since its inception, its prominence surged notably   from 2018 onwards, especially with the rise  of DeFi and the introduction of flash loans.

[00:05:53]In these early days, MEV opportunities  were primarily seized by outbidding rivals   in the public mempool, marking the era  known as PGA, or Priority Gas Auction.

[00:06:04]Imagine two MEV bots seeing a profitable  MEV opportunity. Let’s say there is a   cross-DEX arbitrage that can capture 0.1  ETH of value. Both bots are incentivised   to keep increasing their bids until  the opportunity becomes unprofitable.

[00:06:20]Now, imagine this intense standoff but  compressed within Ethereum's typical   block time, which was averaging  13 seconds pre-Merge. Once a bot   secures its transaction in a confirmed  block, the profit window vanishes.

[00:06:34]In this scenario, while the winning bot  pays the full transaction cost to secure   its spot in the block, the competing  bot often finds its transaction included   as well - but as a failed attempt,  still incurring some transaction fee.

[00:06:48]Extrapolate this scenario to hundreds or even  thousands of bots competing for analogous   profitable opportunities, and we can quickly see  why this became a huge problem. Such aggressive   bidding not only escalated transaction fees  but also contributed to network congestion,   detrimentally impacting Ethereum's regular users.

[00:07:07]This chaotic chapter of early MEV  and its Priority Gas Auctions was   well documented in “Flash Boys 2.0”.  The name of this paper was inspired by   the famous Michael Lewis book Flashboys,  which dives deep into the early days of   high-frequency trading - a concept with  a lot of analogies to the MEV world.

[00:07:27]To mitigate problems caused by PGAs,  a group of Ethereum community members   rallied around and formed Flashbots  with the primary goal of addressing   the negative externalities of MEV in a  transparent and community-driven manner.

[00:07:42]After deeply investigating MEV  to understand its dynamics,   the Flashbots community introduced two  integral tools: MEV-Geth and MEV-Relay.

[00:07:51]MEV-Geth is a modified version of the Ethereum  Geth client that enables miners to communicate   directly with the MEV searchers and  prioritise their transaction bundles.

[00:08:02]These bundles are groups of transactions  packaged together by searchers to extract   profitable MEV opportunities.  MEV-Relay, on the other hand,   is a relay network facilitating the submission  of these bundles from searchers to miners.

[00:08:16]The term "searchers" refers to entities or  algorithms searching the Ethereum mempool   for MEV opportunities, crafting specialised  transaction bundles to maximise potential profits.

[00:08:27]With MEV-Geth and MEV-Relay, miners, instead of  just relying on the transactions in the mempool,   would run these additional pieces of  software to gain access to another   transaction flow that otherwise  wouldn’t be visible in the mempool.

[00:08:41]A miner would look at the mempool and transaction   bundles coming through MEV-Relay and  construct the most profitable block.

[00:08:48]Together, these tools aimed  to create a more organised,   transparent, and efficient  framework for MEV extraction,   reducing network congestion and aligning  incentives among different participants.

[00:08:59]Over time, MEV-Geth started  gaining more and more market share,   reaching around 90% of the mining power.

[00:09:06]Although it looked like the MEV landscape  matured and the main pain points were addressed,   the space was ready for a big disruption  caused by one of the most significant   changes to Ethereum itself - the shift from  Proof-of-Work to Proof-of-Stake and the Merge.

[00:09:22]In the post-Merge world, the concept  of miners on Ethereum ceased to exist.

[00:09:27]Validators were now the entities  responsible for adding blocks to the chain.

[00:09:31]Alongside this shift, MEV evolved from "Miner  Extractable Value" to "Maximal Extractable Value."

[00:09:38]Anticipating these changes, Flashbots, together  with client teams and the Ethereum Foundation,   commenced the development of a new protocol  dedicated to Proof-of-Stake Ethereum called   MEV-Boost, which was activated as  soon as the Merge was completed.

[00:09:52]MEV-Boost is a type of proposer-builder separation  (PBS). PBS is a design philosophy that allows   validators to effectively use third-party  block builders for their block-building duties.

[00:10:05]A block builder is a new role introduced by PBS.  Using MEV-Boost, validators can sell blockspace to   specialised third parties called block builders,  which collect, sequence and introduce transactions   to produce a block. Builders want to produce  a block that maximises the fees collected.

[00:10:25]MEV-Boost works by allowing validators to  pick the highest-paying block offered by   builders. Builders then compete to  produce blocks. The validator then   chooses the highest-paying block  and proposes it to the network.

[00:10:39]Unlike MEV-Geth, where miners had to run  Flashbots software alongside their client,   MEV-Boost operates as an add-on,   allowing any validator to use it regardless of  their chosen consensus and execution clients.

[00:10:52]Yet again, the solution started  quickly gaining significant adoption,   reaching around 90% of the network participants.

[00:11:00]Although the MEV ecosystem undergoes frequent  changes, let's paint a comprehensive picture of   the current MEV landscape by examining  the MEV supply chain step by step.

[00:11:11]The journey begins with a user initiating  a transaction from their wallet. Typically,   this transaction ends up in the  mempool, although alternative private   mempools such as Protect (by Flashbots) and  mev-blocker (by Cowswap) are also available.

[00:11:26]This is where searchers come  into play. They search for the   most optimal and profitable transaction  bundles and send them to the builders.

[00:11:33]The builder, with access to multiple  searchers, potential private order flows,   and the mempool itself constructs the most  valuable block it can and sends it to a relay.

[00:11:44]Validators are connected to  multiple relays and listen   to all the incoming blocks from multiple builders.

[00:11:50]The validator that becomes the next block proposer  selects the most profitable block and proposes it.

[00:11:57]As we can see, the current landscape  diverged significantly from the early,   straightforward Ethereum model of  user → wallet → mempool → miner.

[00:12:06]Although this system is more complicated,   it allows participants to benefit from  builders' work without needing to trust them.

[00:12:14]Outside of the current MEV landscape, It’s  also worth discussing the future of this space.

[00:12:20]One of the main challenges in the current  landscape is builder centralisation. Currently,   the five main builders build  around 90% of Ethereum blocks.

[00:12:29]Additionally, exclusive order flow  and cross-domain MEV present new,   emerging centralization threats to not  only Ethereum but many other chains.

[00:12:39]To address these problems,   Flashbots started working on two new  initiatives: MEV-Share and SUAVE.

[00:12:45]MEV-Share focuses on creating a permissionless  and private matchmaking protocol between users   and searchers where users can benefit  directly from the MEV they generate.   Users can access MEV-Share automatically by  sending transactions through Flashbots Protect.

[00:13:02]SUAVE (the Single Unifying Auction for Value  Expression) unbundles the mempool and block   builder roles from existing blockchains and  offers a highly specialised and decentralised   plug-and-play alternative. SUAVE  is currently being developed,   with a first release expected sometime in 2024.

[00:13:21]There are also some optimisations  that can be applied to MEV. One   of them is MEV-Burn, proposed by Justin Drake.

[00:13:28]It describes a simple enshrined PBS add-on to   smooth and redistribute MEV spikes  - a design similar to EIP-1559.

[00:13:37]Speaking about enshrined PBS, it will  be interesting to see its impact on   existing out-of-protocol implementations of PBS,   such as MEV-Boost and the MEV space  in general, once it’s materialised.

[00:13:49]We’ll, for sure, dive deeper into some  of these topics in the following videos.

[00:13:53]To sum up, MEV, with its intricate  dynamics, is a fundamental aspect of   the Ethereum machine. The MEV extraction  is a perpetual dance, with searchers,   builders and block proposers on a  relentless quest for MEV rewards,   countered by the Ethereum community's pursuit  of a balanced, fair and efficient ecosystem.

[00:14:14]At the time of this video, the size of MEV  opportunities on Ethereum itself lay in   upwards of 320,000 ETH - and this is just since  the Merge. That's roughly 800 ETH/day of MEV.

[00:14:28]The future is still uncertain: Will  we advance towards an MEV utopia,   decentralising all aspects of the MEV supply  chain and returning the generated MEV to   users? Or might we see an MEV dystopia emerge,  where a few centralised entities control block   production across all significant chains,  extracting value from unsuspecting users?

[00:14:49]It’s going to be fascinating to  watch how the MEV landscape evolves.

[00:14:53]So what do you think about MEV and  its impact on the future of Ethereum   and cryptocurrency in general? Comment down below.

[00:15:00]And as always, if you enjoyed  this video, smash the like button,   subscribe to my channel and check  out Finematics on Patreon to join   our DeFi community. Thanks for watching!