MEV: The Hidden Game Behind Ethereum Transactions

Did you know that every time you make a transaction on the Ethereum blockchain, a lot of behind-the-scenes activities (some of them quite shady) take place?

What if I told you that these activities could sometimes lead to cheaper, more efficient transactions, or conversely, be the reason for unexpected high fees and delays?

Welcome to the world of MEV. In this article, you’ll discover the roles of searchers, builders, and proposers in the MEV process. We’ll also look at how Flashbots fit into this picture and what they aim to achieve. Lastly, we’ll discuss whether MEV offers extra incentives for validators or poses a risk to the decentralization of the Ethereum network.

What is MEV?

To understand MEV (Maximal Extractable Value), let’s first consider a simplified model of how Ethereum transactions typically work. When you initiate a transaction, it enters the ‘mempool’, which acts like a waiting room for pending transactions. When a new block is being built, the block proposer selects and prioritizes transactions based on their fees. MEV adds a twist by allowing block proposers to not only choose and reorder transactions but also include their own. This sequence manipulation can sometimes yield significant profits.

Imagine this scenario… Alice buys a large amount of a specific token, followed by Bob who decides to sell the same token. If Bob’s transaction is processed after Alice’s, he benefits from a better sale price due to the increased demand. Block proposers might rearrange the order to capitalize on these opportunities. They could insert their own buy transaction before Alice’s and place a sell transaction after Alice’s but before Bob’s.

In this example, the block proposer front-runs Alice’s transaction, benefiting from the predictable price movement. This additional profit from altering transaction sequences is known as MEV.

How Does MEV Affect Ethereum?

From a user’s perspective, MEV can affect trade executions. For instance, you might receive fewer tokens from a DEX trade than expected due to MEV.

From the network’s perspective, MEV poses a risk of pushing a decentralized system towards centralization. Under proof-of-work, mining pools became highly specialized, leading to potential centralization. This mirrors issues in traditional finance, moving away from the ideal of a transparent, decentralized finance model.

There are really five critical MEV Strategies to be aware of.

Common MEV Strategies

There’s various ways to use MEV but for the purposes of this article, there are five distinct methods that are common.

• Frontrunning: Proposers spot a pending transaction in the mempool that can shift the market and jump ahead to benefit from the price change.
• Backrunning: Proposers position their transaction right after a significant one, exploiting potential price discrepancies or arbitrage opportunities between exchanges.
• Sandwich Attacks: Combining front-running and back-running, proposers see a large order, place their own order ahead of it (front-run), and then place another order after it (back-run), “sandwiching” the user’s transaction.
• Censorship: A proposer might censor transactions to benefit from MEV elsewhere, demand higher fees, or manipulate oracles.
• Generalized Frontrunning: A proposer executes any profitable transaction for themselves by simulating transaction execution to determine if the caller of a smart contract method ends up with more funds.

Toxic vs. Non-Toxic MEV
Another important distinction is the intent behind MEV usage.

• Toxic MEV: This has negative effects on the blockchain ecosystem and its users, such as front-running, sandwich attacks, and censorship.
• Non-Toxic MEV: This doesn’t negatively impact users or the blockchain’s integrity. Back-running is a prime example. However, the classification can be subjective. While arbitrage and back-running lead to more efficient prices, they also cause losses for liquidity providers.

The Evolution of MEV

MEV has been part of Ethereum since the beginning, but its significance surged notably from 2018 onwards with the rise of DeFi and flash loans. In the early days, MEV opportunities were mainly seized by outbidding rivals in the public mempool, marking the era known as Priority Gas Auction (PGA).

Flashbots and the New MEV Landscape
To mitigate the issues caused by PGAs, the Ethereum community formed Flashbots to address MEV problems transparently. Flashbots introduced MEV-Geth and MEV-Relay to create a more organized and efficient framework for MEV extraction.

With Ethereum’s shift from Proof-of-Work to Proof-of-Stake, validators replaced miners. Flashbots introduced MEV-Boost, which allows validators to sell block space to specialized block builders who collect, sequence, and introduce transactions to produce the most profitable block.

The introduction of Flashbots significantly changed the MEV landscape. Flashbots’ MEV-Geth is a modified version of the Ethereum Geth client that lets miners communicate directly with MEV searchers and prioritize their transaction bundles. These bundles, crafted by searchers, group transactions to extract profitable MEV opportunities. MEV-Relay, a relay network, facilitates the submission of these bundles from searchers to miners.

With MEV-Geth and MEV-Relay, miners could access another transaction flow not visible in the mempool, allowing them to construct the most profitable block. This organized approach aimed to reduce network congestion and align incentives among participants.

With Ethereum’s transition to Proof-of-Stake, validators took over the role of miners. Anticipating this shift, Flashbots, in collaboration with client teams and the Ethereum Foundation, developed MEV-Boost for Proof-of-Stake Ethereum. MEV-Boost is a type of proposer-builder separation (PBS) that lets validators use third-party block builders for their block-building duties.

Builders compete to produce the highest-paying block, which validators then propose to the network. Unlike MEV-Geth, MEV-Boost operates as an add-on, enabling any validator to use it regardless of their chosen clients. This solution quickly gained significant adoption, with around 90% of network participants using it.

The Current MEV Landscape
The current MEV landscape involves multiple steps and participants:

1. User Initiates a Transaction: The journey begins with a user initiating a transaction from their wallet. This transaction usually ends up in the mempool, although private mempools like Flashbots and mev-blocker are also options.
2. Searchers: Searchers scan the mempool (and private pools) for optimal and profitable transaction bundles and send them to builders.
3. Builders: Builders, with access to multiple searchers, private order flows, and the mempool, construct the most valuable block and send it to a relay.
4. Validators: Validators are connected to multiple relays and listen to incoming blocks from builders. The validator that becomes the next block proposer selects the most profitable block and proposes it to the network.

This complex system allows participants to benefit from the work of builders without needing to trust them.

What Does the Future of MEV look like?

One of the main challenges in the current landscape is builder centralization. Currently, the top five builders construct around 90% of Ethereum blocks. To address this, Flashbots is working on initiatives like MEV-Share and SUAVE to create a more decentralized and fair ecosystem.

MEV extraction is a continuous game with searchers, builders, and block proposers all vying for MEV rewards. The Ethereum community’s goal is to balance these dynamics for a fair and efficient ecosystem.

Right now, the future remains uncertain. Will we move towards an MEV utopia, decentralizing all aspects of the MEV supply chain and returning the generated MEV to users? Or might we see an MEV dystopia, where a few centralized entities control block production across all significant chains, extracting value from unsuspecting users?

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