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What is Maximal Extractable Value (MEV) and Flashbots?

The world of cryptocurrencies has brought incredible amounts of innovation to the traditional financial segment. There are countless new terms, concepts, technologies or ideas that have come straight out of the crypto industry, which were not discovered, invented or thought about before.

One of such concepts is Maximal Extractable Value (MEV). In theory, this term looks very similar to simple arbitrage that is happening in the traditional financial industry, or in the world as such. However, upon closer review it shows that MEV is not quite as similar to arbitrage as it may seem at the first glance.

What is the Maximal Extractable Value (MEV)?

Maximal Extractable Value (MEV), previously also known as Miner Extractable Value, refers to a maximum value that can be extracted from the production of blocks that is in excess of what the standard block reward and gas fees produce. This can be done for instance by excluding, including or changing the order of transactions that are in the given block.

Traditionally, this was thought to be a “job” only for miners, which was also one of the reasons why initially it was called Miner Extractable Value. However, with new entities emerging solely for the purpose of profit maximisation and the democratisation of the mempool, the term was changed. It was also changed due to the fact that for instance Ethereum has moved from Proof-of-Work concept to Proof-of-Stake concept, where there are no longer miners, but validators.

What is interesting about MEV is that it was never planned to happen on Ethereum or any other blockchain. It was simply an outcome that came out of the current design. However, what it means is that the blockchains “suffering” from MEV would need to either accommodate for these new influences or somehow adjust for them. For the future blockchains, it is expected that the developers will have MEV in mind and will either try to take it into account from the start or to put in place systems that will be able to forgo it.

The reason for that is quite simple. As the entities will be looking more and more for MEV opportunities, they can congest the network, increase the gas fees or prolong the transaction time all in sake of their profit maximisation. Flashbots, which will be discussed later in the article, are one of the solutions for this. But before we examine their impact on MEV and blockchains such as Ethereum, let’s first talk more about the above-mentioned entities.

Understanding MEV and Flashbots, Source: Mycelium

Who are MEV searchers?

MEV searchers are independent network participants, who are trying to extract as much value from MEV as possible via several tools. Usually, they run algorithms to detect any discrepancies or profitable MEV opportunities. They also have bots that automatically exploit them and submit all transactions to the network.

Thanks to this, the searchers can easily affect which transactions will be either included or excluded from the block. They can also affect which of the transactions in the mempool will be changed, since they are mostly working with mempool and the information it gives them. Timing and pricing of their actions is crucial, however, if exercised correctly, they are able to profit by extracting as much MEV as possible.

An example of their behaviour is as follows. Once the MEV searchers detect an opportunity for MEV arbitrage once it lands on-chain, they can send two transactions that will complete the arbitrage opportunity. This can be done either to the flashbots private relay or directly into the mempool.

If this is all done correctly, all the transactions, the one that created the opportunity as well as the two transactions of the MEV searchers, will all be mined in the same block. This also means that the arbitrage opportunity will not only begin, but will also cease to exist all in the same block.

What is important to say is that the miners or validators who “help” MEV searchers to capitalise on their arbitrage opportunities, are then sharing some profit with the searchers from MEV. This is simply because the MEV searchers are incentivised to pay higher gas fees, which are going straight to the miner or validator. Thanks to this, MEV searchers increase the chances of their transactions to go into the block with the arbitrage opportunity.

The gas fees that the MEV searchers are willing to pay to the validators or miners will be up to 100% of their MEV opportunities. If it is higher, the searcher would lose money on such trade, making their actions irrational and unprofitable. 

While that does not happen quite often, in some of the more competitive fields such as decentralized exchange arbitrages, the MEV searchers have to pay up to 90 % of their potential profits to the miners or validators, to ensure they will be able to benefit from the found opportunities. The higher the gas fee they offer to the miner, the higher the chance their transactions will be put to the block.

Did The Merge have an effect on MEV?

When it comes specifically to Ethereum, The Merge had so far little to no effect on MEV and vice versa. While the searchers are no longer looking for miners, but rather validators, they still need to pay them fees to have their transactions included in the blocks. In this case, the switch from Proof-of-Work to Proof-of-Stake has not change much.

Thus, the only change that has happened so far is probably the change in the name from Miner Extractable Value to Maximum Extractable Value. The perception of what it actually is might have changed a bit as well, however, for the more significant impact of The Merge on MEV or MEV on The Merge we need much more time and data. All the MEV opportunities for searchers still remain in place. And here are some of them explained a bit in-depth.

Source: Outlier Ventures

Front-running and Sandwich trade

Front-running is probably one of the most popular approaches to MEV. While it looks pretty simple in theory, in practice it is more difficult as a lot of things need to align, which is a reason why not everyone can be an effective and profitable front-runner. To put it simply, front-running is looking for profitable transactions or trades in the mempool and copying them with a goal of cutting in line while seeking a profit. This approach profits from the inefficiencies of MEV.

Another type of this behaviour or arbitrage opportunity is known as sandwich trade or sandwich attack. In this case, the entity, usually front-runners, first calculate the resulting price action of the queued trade. If it seems profitable, the front-runners execute the trade with a larger gas fee, which means they jump ahead the transaction they want to overcome, and immediately sell once the previous trade is settled. If this is done in such a way that the gas fee that they paid for the jump ahead is less than the price movement, they make a profit.

There are other possibilities of how people can engage with MEV or blockchains as such. Head of protocols and opportunities at Figment, Clayton Menzel, said the following on this topic.

“Folks have realised there are different ways to engage with Ethereum. Typical users may just want to transfer ETH. However, folks engaging in MEV exhibit more of a reaction to what is happening on the network. It’s iterative and reflexive. They are watching the pending transaction pool, watching what others are doing.”  

What are Flashbots?

Flashbots is an open-source research and development organisation that has mitigation of the negative externalities of MEV as their main goal. It tries to help Ethereum and similar blockchains in avoiding the risks connected to MEV. They try to do so by creating an opportunity for a permissionless, transparent and fair ecosystem for extraction of MEV.

The main contribution of Flashbots is the reinforcement and standardisation of the MEV, its controls and limits. Quite recently the Flashbots have also decided to focus on satisfying the properties of complete privacy and finality to the MEV auctions. These auctions work as shown below:

Simplified version of how Flashbots work, Source: Bitmex

As the chart shows, the main goal of Flashbots is to connect the searchers and miners, mining pools or validators directly through an open system. It can be joined by both the searcher as well as the mining or validating entity.

The logic of this step ensures that the bidders, in this case searchers, do not know the price of other bidders. Thus, if they want to make sure that their transaction is included in the block, they need to pay a substantial amount in gas fees to the miners.

Just like Ethereum, Flashbots are still being developed, improved upon and implemented. For example, one of their recent projects called SUAVE is trying to improve the privacy of the MEV-Boost. SUAVE is expected to be open-source, MEW-aware, privacy-focused and an encrypted mempool for users and wallets.

Conclusion

MEV has been part of the Ethereum blockchain, as well as other blockchains, for quite some time. One might even say that they have been present ever since their inception. However, the opportunities these processes bring have been more discussed mostly recently, especially with the birth of decentralized exchanges.

These platforms helped create a bigger demand for MEV as they allowed searchers to go above and beyond in finding arbitrated and profit maximisation opportunities. While Flashbots are trying to create an equal environment for anyone who wants to take part in it, it is safe to assume that MEV will be in constant development as it will be affected by anything that the crypto market can bring.

 

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