Popular Science | What is Miner Extractable Value (MEV)?

Original article: https://blog.chain.link/what-is-miner-extractable-value-mev/

Note: This article has been slightly edited based on the original text.

The total value of the blockchain economy has surpassed $1 trillion and continues to grow at an exponential rate, with the value of the DeFi ecosystem alone doubling since the beginning of the year. However, with the growing popularity of smart contracts, new vulnerabilities have been discovered where value can be lost without the user's knowledge. One example of this is Miner Extractable Value (MEV) - a blockchain miner can profit at the expense of users by dynamically reordering transactions (including or excluding transactions within a block). Simply put, miners can determine the order in which transactions are processed on the blockchain and use this ability to their own advantage.

Researchers including Chainlink Labs researchers Ari Juels and Lorenz Breidenbach wrote a research paper titled "Flash Boys 2.0" in which MEV and transaction reordering are not just a theoretical concept, but one that has already appeared on decentralized exchanges in the form of front-running transactions, which may seriously affect the user experience. In this article, we will explore why MEV appears and what examples of MEV exist now.

Why Miners Can Extract Value

Blockchain networks such as Bitcoin and Ethereum are immutable ledgers protected by a decentralized network of computers called "miners". These miners are responsible for periodically packaging pending transactions into blocks, which are then verified by the entire network and added to the global ledger. While the blockchain network ensures that all transactions are valid (for example, no double spends occur) and that new blocks of transactions are continuously produced (to prevent downtime), it does not actually guarantee that transactions will be ordered in the same way as they are submitted to the blockchain.

Since each block can only contain a limited number of transactions, miners have full autonomy in choosing which pending transactions in the mempool, which is where miners store unconfirmed transactions off-chain, to include in their blocks. While miners typically process transactions with the highest gas price (transaction fee) in order to maximize profits, this is not a requirement of the network. Therefore, miners can use their ability to arbitrarily reorder transactions to extract additional profits from users, creating value known as miner extractable value (MEV).

By default, miners process transactions not based on the time the user submitted them, but rather based on the amount of fees the user paid.

While the concept of MEV is the most common term, most forms of MEV we see today do not come from miners themselves, but from third-party bots. These bots manipulate the order of their transactions within a block by changing the transaction fees paid to miners. This means that even if miners process transactions based on the highest gas price, MEV will still be generated. However, because miners ultimately control the final transaction order within a block, MEV can be seen as an upper limit on the value that miners can extract.

MEV comes at the expense of ordinary users, who are often not aware of this until after the transaction is completed. This may include increased network transaction fees and additional slippage on transactions, both of which directly take value from users.

Exchange Arbitrage and Gas Price Bidding Wars

The most common form of MEV currently is a third-party robot that performs arbitrage between two or more decentralized exchanges (DEX). Arbitrage opportunities arise when the price of a cryptocurrency asset on one exchange deviates from the price on another exchange, usually due to large-scale transactions on one of the exchanges. Arbitrage robots buy assets at a lower price on one exchange and sell them at a higher price on another exchange, making a profit while bringing the prices of both exchanges back to the same level. In addition, there are also many arbitrage opportunities between decentralized exchanges on the chain and centralized exchanges off the chain.

As DeFi projects increase and liquidity increases within centralized exchanges, the occurrence and profitability of these arbitrage opportunities increase, leading to increasing competition among arbitrage bots. These bots compete for arbitrage opportunities by engaging in bidding wars, which causes them to continuously increase the transaction fees they are willing to pay to miners in an attempt to get their transactions processed first. They behave in this way because they know that miners, as rational economic actors, are incentivized to process transactions based on the highest gas price. Although this form of MEV ensures consistent market prices across exchanges, it has an unfavorable side effect.

The result is that the bandwidth of the blockchain network is consumed by increasingly competitive arbitrage exchanges, which increases transaction fees for others on the network. The transaction fees paid by arbitrage bots usually account for a large part of the final profit of arbitrage, and this part of the value ultimately flows directly to miners. This means that miners can benefit from this form of MEV even if they do not seize arbitrage opportunities themselves, because their transaction fee income will increase.

Exchange frontrunning and “invisible fees”

Another form of MEV that could be considered more directly harmful to the user experience is bots that front-run transactions for users on decentralized exchanges. Because all transactions from users must go through the memory pool, these front-running bots can monitor large transactions entering the memory pool and use this "foreign" ability to their own advantage.

For example, if a bot spots a large trade, a front-running bot can copy the user's trade and pay a higher transaction fee to have their trade processed first. This moves the market price of the traded asset, causing the user's trade to incur greater slippage (the difference between the expected price of a trade and the actual price). After the user's trade is processed, the market price of the traded asset shifts further in the front-runner's favor, allowing them to profit by selling the asset.

As a result, users’ trades are executed at suboptimal rates, which adds an “invisible fee” to using a decentralized exchange in the form of receiving fewer tokens than originally intended. Similar to exchange arbitrage, front-running bots increase the cost of creating any transaction on the blockchain network by engaging in transaction fee bidding wars to get their trades processed first in order to gain access to these opportunities.

Exchange arbitrage and front-running are just two examples of how MEV can arise and potentially negatively impact users. However, they are not the only cases where MEV could exist. If miners start taking more MEV opportunities, they could use more advanced transaction reordering strategies to further extract value from users. Arbitrage bots and front-running bots can only reorder their transactions by paying higher transaction fees, while miners can reorder the blocks they mine for free. This further creates more opportunities for MEV, and in the worst case, could lead to block reorganizations and consensus instability.

Original article: https://blog.chain.link/what-is-miner-extractable-value-mev/

Author: Chainlink

Compiled by Captain Hiro