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What Is Maximum Extractable Value (MEV)?

Unlike a lot of things in the crypto world, MEV is pretty well named. It is exactly what it sounds like. Given how blockchains are constructed and all the entities involved with aggregating/including/executing/broadcasting transactions, MEV is the maximum amount of economic value these privileged entities (some would even use the crypto slur “middlemen”) can squeeze out (extract) of each on-chain transaction. Sounds sh*tty at first glance, right? And you’re not entirely wrong. But just like with anything, as you learn more, it’s not so black-and-white. However, one thing is for certain, MEV is here, happening, and it isn’t going away any time soon (if ever). Therefore, an entirely new industry within the crypto economy has been created in the last 2-3 years and it’s big business.

So, again, but this time a more formal definition: Maximal Extractable Value (MEV) represents the total economic benefits block producers can obtain by arbitrarily including, excluding, and reordering transactions. Initially referred to as "miner extractable value," the term evolved to encompass a broader meaning as Ethereum (where most everything happens in crypto land, including MEV opportunities) moved to Proof of Stake, eliminating miners, and, thus, making it a less applicable term. Miners were replaced with validators and “Maximum Extractable Value” made more sense.

Source: BlockNative

“Soooo… I thought cryptocurrencies were peer-to-peer (p2p), meaning no middlemen. Isn’t that kind of one of its core principles? And now, you’re telling me there’s an entire industry of middlemen looking to profit off me?”

To understand MEV, it is essential to grasp the process of block production in blockchains. Contrary to popular belief, transactions in blockchains are not recorded on a first-come, first-served basis. Instead, blockchains operate more like auction houses, selling block space to the highest bidder.

Blockchain networks consist of computer nodes called block producers, including miners (PoW), validators (PoS), and sequencers (L2). These block producers collect user-submitted transactions and generate blocks. Since each block can accommodate only a limited number of transactions, block producers prioritize transactions with the highest gas fees when demand is high to maximize their profitability. This extra profit obtained by block producers from users by selectively including, excluding, and reordering transactions is what we call MEV.

Source: Xangle

MEV exists primarily because (i) block space is limited (e.g., 30M gas maximum for Ethereum), (ii) all blockchain activities are publicly visible, (iii) there is a fee market, and (iv) block producers have control over transaction ordering.

MEV “Attacks” and How Users Suffer

MEV attacks come in various forms. The primary types of MEV attacks include:

1. Front-Running: This occurs when an attacker takes advantage of a highly profitable transaction (e.g., arbitrage) identified in the mempool by duplicating the transaction but with a higher gas fee. This allows them to "steal" the opportunity from the original user.
2. Back-Running: In contrast to front-running, back-running involves generating a profit by placing an order immediately after a target transaction has been executed. A common example of back-running is an MEV bot placing an opposing order right after a temporary high slippage occurs due to a large-scale transaction, allowing it to profit from arbitrage trading.
3. Sandwich Attack: This type of MEV attack combines both front-running and back-running, generating profit before and after the target transaction when successful. Such attacks often occur on AMM DEXs like Uniswap. An illustration of this is when a user submits a large buy order for a particular cryptocurrency, which is projected to raise the price from one value to another. The MEV bot anticipates this, purchases the memecoin ahead of the transaction, and then supplies liquidity to the DEX at a slightly higher price. The targeted order proceeds to buy all the memecoin from the bot at the inflated price, making a risk-free profit for the bot. Following the temporary inflation, the bot sells off its inventory at a higher price (known as back running) and then repurchases it after the market correction, exploiting passive liquidity providers.
4. Liquidation: MEV bots can also monitor lending protocols like MakerDAO and Aave in real-time for opportunities to liquidate a user's position and profit from the liquidation fee. These bots exploit vulnerable positions by liquidating them when the opportunity arises, earning a profit through fees associated with the liquidation process.

Sandwich Attacks

To understand how a sandwich attack works, it is important to understand how the price of an asset is calculated on the blockchain. The price of an asset is typically calculated as the current exchange rate between assets. For example, if a contract is currently trading 10 USDC for 100 CEQcoin, then you could say CEQcoin has a price of 0.10 USDC.

However, prices generally move in response to buying and selling pressure. If a large order is sitting in the mempool, traders have an incentive to copy the order but with a higher gas price. That way, they can purchase the asset before the large order, let the large order move the price up, and then sell the asset right away.

Source: Xangle

The sell order is sometimes called “backrunning.” The sell order can be done by placing a sell order with a lower gas price so that the sequence looks like this:

1. Frontrun buy
2. Large buy
3. Sell

The primary defense against this attack is to provide a “slippage” parameter. If the “frontrun buy” itself pushes the price up past a certain threshold, the “large buy” order will revert, making the frontrunner fail on the trade.

It’s called a sandwich because the large buy is sandwiched by the frontrun buy and the backrun sell. 

Malicious MEV activities, such as front-running or sandwich attacks, significantly impair user experiences. As long as MEV bots exist, amateur traders have almost no chance of profiting from arbitrage opportunities they fairly identified. Users' funds are frequently exploited, as demonstrated in the "Ethereum is a Dark Forest" example. MEV-Explore reports that the total extracted MEV since January 2020 amounts to approximately $675 million (with the actual MEV estimated to be much higher) as of October 29, 2022.

The intense competition caused by PGA leads to network overload and gas fee inflation. For instance, the average gas fee skyrocketed to 474 gwei during Yuga Labs' Otherdeed sale on May 1, and miners and bots extracted $44 million in MEV on the day the Chinese government announced a ban on using crypto assets on May 19, 2021.

Malicious MEV activities can severely threaten network security and pose centralization risks. A prime example is time bandit attacks, in which MEV attackers re-execute blockchain history to steal profit, undermining network stability and trust. This type of attack can occur when block rewards are significantly smaller than MEV profits. Attackers are more likely to target smaller blockchains with weaker security.

Mitigating MEV: Request for Quotation and Batch Auctions

Here are some tips for avoiding sandwich attacks:

• Use a slippage parameter.
• Monitor the mempool for large orders.
• Use a decentralized exchange (DEX) that uses a fair ordering mechanism.

By following these tips, you can help to protect yourself from sandwich attacks.

The evolving DeFi landscape offers several solutions to guard transactions against MEV. One such method is the Request for Quotation (RFQ) process, which allows liquidity takers to trade directly with a market maker. The RFQ process provides several advantages, including best pricing, off-chain negotiation, and protection against front-running or sandwich attacks.

Another innovative solution is the batch auction process utilized by platforms like CowSwap, built on the Gnosis protocol. The batch auction process matches opposite trades in a given batch without necessitating a liquidity pool DEX, thus circumventing swap fees. Notably, CowSwap also provides gas-free trading, best execution, and the potential for price improvement via the batch auction.

MEV-Burn: A Long-Term Solution for Ethereum's MEV Challenges

MEV-Burn is a key component of Ethereum's multi-year roadmap, devised to address the issues surrounding Maximum Extractable Value (MEV) directly. The primary goal of MEV-Burn is to redirect MEV back to ETH holders by burning the value currently extracted by MEV participants. This redistribution effectively adds scarcity to the asset and alleviates selling pressure on block validators.

Stabilizing MEV Profits: The Secondary Objective

In addition to redistributing value to ETH holders, MEV-Burn aims to reduce chain instability by leveling MEV profits for block builders. This process, known as "MEV-smoothing," intends to make MEV rewards more predictable and stable, rather than the current high-risk, high-reward system in place today.

The challenge with MEV-Burn is the need to quantify MEV based on what block proposers (or builders) are willing to neutrally pay for it in an efficient market. Currently, the block-building market is an opaque, off-chain market characterized by fluctuating MEV profits. To resolve this issue, MEV-Burn requires the completion of another major Ethereum network upgrade: proposer-builder separation (PBS).

Proposer-Builder Separation: A Prerequisite for MEV-Burn

PBS divides the traditional validator role into two separate functions: proposers and block builders. By doing so, it prevents block builders from simultaneously selecting and ordering transactions to be included in a block. This separation eliminates the opportunity for block builders to engage in transaction discrimination, which is the core of MEV. Read more about PBS in greater detail here. 

Upon the completion of PBS, block proposers will no longer have the ability to determine the value of including transactions in a specific order. As a result, proposers will be forced to submit neutral fee bids for the blocks that block builders have assembled. This on-chain market process will replace the existing off-chain market facilitated by Flashbot’s third-party MEV-Boost software.

Advantages of MEV-Burn

Currently, Ethereum issues ~685,000 ETH annually as rewards for ETH validators. This issuance is compounded as validators vie for a share of MEV profits, which in turn increases issuance. MEV-Burn is projected to reduce this annual issuance by an estimated 400,000 to 500,000 ETH.

Stabilizing MEV profits also means reducing incentives for block validators to redirect capital towards staking, particularly during bull markets when issuance rewards are heightened. This expands the economic bandwidth of ETH and preserves capital for decentralized application (dapp) collateral, such as decentralized stablecoin collateralization, lending, and other forms of staking.

It is important to note that MEV-Burn is not a short-term solution, with implementation expected within a 3-5 year time frame. However, its potential to lead Ethereum out of the MEV dark forest makes it a worthwhile wait for the community.