MEV and The Merge
What is MEV?
MEV, or Max Extractable Value, is the amount of profit that can be made from a blockchain transaction in addition to transaction fees and block production rewards.
While a blockchain uses a Proof of Work (PoW) consensus mechanism, miners append new transactions to the blockchain which entails choosing, ordering, and proposing transactions. Therefore, in a PoW environment, the miners can benefit from executing MEV tactics. However, while a blockchain uses a Proof of Stake (PoS) consensus mechanism, block builders and block validators are both responsible for block production. The separation of the builder/proposer roles is optional, and it is theorized that the builders will stand to benefit from pursuing MEV opportunities in an Ethereum PoS environment.
In practice, there are specialized searchers, also known as MEV bots, that scan the mempool where pending transactions are queued. The searchers are highly specialized in identifying and capturing MEV, and have a profit-sharing arrangement with block builders.
A Few MEV Examples
DEX Arbitrage
The most common form of MEV is a DEX arbitrage opportunity. If one DEX lists a token at a different price than another DEX, that token can be bought from the lower-priced DEX and sold on the higher-priced DEX, and this would all occur in a single atomic transaction, reducing the risk of a change in the profit made on the arbitrage.
Loan Collateral Enforcement
Similar to how a home can be used as collateral for a Home Equity Line Of Credit (HELOC), a great aspect of Decentralized Finance (DeFi) is the ability to use crypto as loan collateral—a.k.a. a crypto-backed loan. Just as with Traditional Finance (TradFi), the lender will require a certain level of collateral to back a loan. And if the level of collateral drops below the required amount, a.k.a. the Loan-to-Value ratio, then the lender can liquidate the collateral.
The same is true in DeFi, but since DeFi runs on smart contracts rather than through a centralized intermediary, the LTV ratio can be monitored by searchers that scan crypto-backed loan smart contracts. This is possible because smart contracts are on-chain, meaning they are recorded on public, fully transparent blockchains.
If a searcher finds a smart contract with collateral that is below the required LTV ratio (typically due to a drop in the price of the underlying token value), then the searcher will enforce the smart contract by liquidating the collateral and returning it to the lender. Per the loan’s smart contract, the borrower pays a liquidation fee which includes a bounty for the liquidator.
Sandwich Attack
Rounding out the last example is a strategy where searchers seek out high-volume transactions that have the potential to influence market prices. Then the searcher will sandwich the large transaction with two other transactions that will benefit from the anticipated change in the market price. For example, if a buy order to purchase 30,000 ETH was queued in a mempool, the searcher could submit a purchase order for ETH and offer higher gas fees so it would execute prior to the larger purchase. Then the searcher would immediately sell that ETH with a transaction that would follow the large transaction and higher market price, allowing the searcher to make a quick profit.
Why Do We Care
In some cases, MEV transactions provide utility within a DeFi ecosystem, such as with the enforcement of smart contract collateral requirements that ultimately protect the lender. However, MEV transactions can also result in less value to the retail investor/trader/DeFi user.
With Ethereum’s previous pre-merge PoW consensus scheme, block builder and block validation activities were both performed by a single blockchain node—the PoW miner. When block builder and validation roles are consolidated to a single mining node, profit maximization activities are more likely to occur between the time a user’s transactions are submitted and when the transaction is officially appended to the blockchain.
This is possible because the miner node has full authority over new block composition and validation, and can take advantage of the unchecked duties by inserting transactions on its behalf that provide extract profit from anticipated market movements, arbitrage opportunities, etc.
Typically, queued transactions paying the highest gas fees were selected to be in the next block. However, according to Flashbot, more than 90% of miners reserve block space for MEV transactions from searchers, when there is a profit-sharing arrangement between miners and searchers. These MEV transactions effectively skip the line, and the result is less valuable for the everyday user.
MEV After The Merge
The largest impact from MEV extraction will come with the introduction of block builder-block proposer separation which is now possible after The Merge, but not yet required. This is widely referred to as Proposer-Builder Separation (PBS). Check out this blog to catch up on our post-Merge coverage.
See our in-depth blog for a broader overview of Ethereum layer-1 and layer-2 blockchain improvements.
Block building is the computationally intensive task of searching the mempool for queued transactions, and then aggregating those transactions into a new block to be proposed for addition to the blockchain. The new block is sent to a validator node that proposes it for addition to the blockchain via PoS consensus.
The diagram below shows the implementation of a Flashbots middleware client called MEV-Boost, which allows Ethereum validator nodes (proposers) to access a marketplace of blocks that are ready to be added to the blockchain. In this model, searchers interact directly with block builders to insert MEV-focused transactions into upcoming blocks. Similar to a PoW environment, this locates searchers between the mempool and block-building activity.
Figure 1. Proposer-Builder Separation using Flashbots middleware
Source: https://github.com/flashbots/mev-boost
Block proposal is the task of proposing a block to the network for validation. It is one of the last steps required to settle a transaction on the Ethereum blockchain because once a block is validated, it is appended to the existing blockchain. In the post-Merge ecosystem, this task is carried out by validator (proposer) nodes. To further prevent validator nodes from extracting profit from upcoming user transactions, rather than expose all transactions within a block when the block is proposed, the transactions can be substituted by a hash value while retaining transparency to fees offered. This allows an auction system where validators can continue to choose blocks that offer the highest fees while simultaneously shielding user transactions from value loss to MEV bots.
Through proposer-builder separation and masking of transaction details, negative MEV effects should be minimized in Ethereum’s post-Merge world while allowing positive MEV transactions to persist.
