The Invisible Tax: What Is MEV and How Does It Impact the Ecosystem?
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The Invisible Tax: What Is MEV and How Does It Impact the Ecosystem?

Maximal Extractable Value or MEV is a strategy employed by block producers to maximize profit by selecting and arranging transactions when generating a new block. The aim is to get the most out of the transaction fees, and block producers take advantage of this due to their capability to choose and organize transactions.

Other participants on the network (called searchers) can also pay fees to submit transactions if they detect a potential to make money from MEV opportunities such as arbitrage, front-running, or liquidation. MEV is most commonly observed in networks running smart contracts, which enable blockchain transactions containing more in-depth data.

Basics

MEV is a process miners or validators employ when selecting transactions for a blockchain block. By strategically reordering, including and excluding transactions, they can generate the maximum profit from a block in addition to the standard rewards and gas fees. This technique essentially makes it possible to glean extra value from each block mined.

MEV is primarily associated with the Ethereum network due to its expansive decentralized finance ecosystem. The more complex transactions involved with a block (such as smart contracts related to lending, borrowing, or trading), the more opportunity block producers have to make increased profits by choosing to include, omit, or reorder those transactions.

MEV Is…

When initially conceived, the concept of MEV was strongly associated with the Ethereum network, which utilized a proof-of-work consensus algorithm. Making miners the gatekeepers of the network, they had the authority to change the order of, add, or omit certain transactions when putting together blocks, allowing them to gain additional income.

The concept of exhausting all avenues of profit was explained by the newly coined term Miner Extractable Value. In September 2022, Ethereum released The Merge — a technical advancement altering the consensus mechanism from a proof-of-work (PoW) to a proof-of-stake (PoS).

Rather than being mined, new blocks on the Ethereum network are now produced by validators using a PoS system. However, this system is not without its own version of MEV, as whoever selects which transactions to include and in what order can maximize their profits from the block. The traditional MEV concept has been re-imagined to apply to anyone, not just miners, and now stands for Maximal Extractable Value.

What Is the Process Behind MEV?

To comprehend the concept of MEV, one must have knowledge of the duties of block producers, such as miners and validators. These block producers are integral in protecting and keeping blockchain networks in operation, and they verify transactions and then add them to their networks in blocks. This action is denoted either as mining or validating, depending on the type of blockchain.

Block producers serve a critical role in maintaining the integrity and longevity of a network. By collecting user transaction data, organizing it into blocks, and adding them to the chain, block producers are responsible for ensuring that new data can be added to the network and that it continues to function as intended.

It is essential to remember that it is the responsibility of the block producers to decide which transactions are recorded in their blocks. It means that they will typically choose those transactions which are the most profitable, meaning those that have the highest fees attached to them. Therefore, in periods of increased traffic, individuals will pay higher gas fees (or transaction fees) to make sure that their transaction is accepted first. For block producers, opting to go with the transactions with the highest fees can result in higher profits. As a result, those who have paid lower fees have to wait longer until their transaction is included in a block.

No regulations exist that dictate which transactions should be chosen or arranged according to their fees. When there are more intricate details in transactions (as is common in blockchains that enable smart contracts), block producers can add, exclude, or organize transactions in a way that earns them more money than merely the standard block rewards and fees.

Selecting transactions and ordering them in a particular way may bring extra financial gain from resultant arbitrage opportunities or on-chain liquidation. Thus, MEV participants may be able to benefit from the transactional fees and other benefits earned through the process.

MEV searchers

Participants, besides block producers, known as "searchers," can also take advantage of MEV. These searchers execute MEV-specific operations that direct them to potentially lucrative opportunities that can be found within the network data.

When competing for a profitable MEV opportunity, searchers may need to pay costly gas fees to block producers in order to guarantee that their strategies are carried out. In some cases, the cost of the gas fee can reach as high as 99.99% of the potential profits from the MEV opportunity.

Look at decentralized exchange arbitrage, for example, where the searchers often pay hefty gas fees to ensure their arbitrage trades are profitable before other similar trades are made. These fees can be greater than 90% of their MEV income.

Examples of MEV

MEV refers to additional revenue sources captured by miners. Arbitrage, front-running, and liquidation are all forms of MEV that block producers can take advantage of to make a profit. To gain a better understanding of MEV, let us now delve into the specifics of each of these revenue streams.

Arbitrage

When the value of an asset differs between exchanges, an arbitrage opportunity is opened. It can often occur in crypto when the same token is sold at different prices on different DEXs. Upon finding the discrepancy, an arbitrageur will make a trade to gain from the price difference. MEV takes place when a searcher's bot identifies the pending transaction and places its own transaction before it to take advantage of the arbitrage opportunity.

Front-running

Block producers and searchers can leverage their capability to arrange transactions in a block to MEV by submitting a similar purchase order ahead of a large buy order currently in the transaction pool, thus securing a better price than the one that would have been offered if the large buy order had gone through first, consequently raising the value of that digital asset.

"Sandwiching" is a similar approach to MEV, where a buy order is placed before, and a sell order is placed after a transaction to capture the price pressure from both sides.

Liquidations

DeFi gives people the opportunity to take out loans that are secured by digital assets held as collateral. If the value of the collateral dips below a certain point, these loans are automatically liquidated through programmatic smart contracts. In return, the party responsible for liquidating receives either a reward or fee for triggering this liquidation.

A potential MEV opportunity is available to any searcher or block producer running bots that can discover liquidation transactions before anyone else. If done successfully, the associated reward value could be seized by the block producer who placed their liquidation transaction in the block ahead of any other participant.

Advantages and Disadvantages of MEV

Engaging in MEV is often viewed as a wise strategy as it typically enables those involved to maximize their profits. Proponents of MEV contend that it also has a positive effect on the larger ecosystem by swiftly correcting any inefficiencies that may arise.

As an example, MEV searchers try to beat each other in capitalizing on arbitrage chances, thus causing speedy price adjustments across DEXs. Similarly, lending protocols are keen on preventing risky loans from slipping in, so if the collateralization ratios get off balance, they resort to MEV liquidation attempts to make sure lenders are reimbursed as soon as feasible.

Despite the potential of MEV, it does come with its drawbacks. Specific strategies, for instance, front-running and sandwiching, are disadvantageous to other traders as they are forced to bear extra costs, experience more slippage, or miss out on potential earnings, thus resulting in a net loss.

As a result of MEV searcher transactions, gas prices and network congestion may rise as they battle to include their transactions in blocks in order to gain rewards.

Suppose the profits from reordering transactions in a previous block exceed the rewards and fees of the subsequent block. In that case, the economic incentive for a block producer to execute a blockchain reorganization may become attractive, and it could compromise the integrity and consensus of the network.

As the ecosystem progresses at a rapid rate, the exploration of solutions for MEV-related issues has become a crucial part of research and development within the crypto space.

MEV
Arbitrage
Front-running
Liquidation
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