On Jun 16, 2022, the Bank for International Settlements (BIS) released a well-researched bulletin titled Miners as intermediaries: extractable value and market manipulation in crypto and DeFi. This bulletin provides a good overview of Ethereum’s Maximum Extractable Value (MEV) mechanism. MEV is the additional profit delivered to miners to prioritize the ordering of blockchain transactions within a given block.
The bulletin compares subtle forms of transaction order manipulation on the blockchain to broader market manipulation, equating MEV to insider trading. Yet, both of these comparisons stretch the similarities.
Most MEV is a result of well-informed investors and high-frequency traders taking advantage of arbitrage opportunities. Arbitrage is natural in most markets and is the mechanism that many economic systems use to achieve equilibrium. Arbitrage communicates price information across markets.
But some MEV does negatively impact the victims. This includes jumping the queue on big trades to take advantage of anticipated price movements in a practice called front-running. Then there’s “sandwich attacks”, a form of front-running with the purpose of seeking pending transactions and placing orders before and after with the intent of manipulating asset prices,
The Ethereum Foundation is aware of these negative externalities and is addressing these inequalities by separating block building from block proposing. After the Merge, miners will stop mining blocks and their function will be filled by two new roles — Block Validators and Block Builders.
Validators will secure the blockchain with their assets and propose blocks for inclusion in the blockchain. Block Builders will assemble and order the “best” blocks they can, which may be sequenced to optimize profits, base order received, or be based on a “fair sequence.”
MEV is Extracted by MEV Searchers
The bulletin states: ”[A miner’s] ability to extract value arises from their control over the composition of the block they are adding to the blockchain.” That is true.
“Miners add their own transactions to the block to profit from a different ordering of pending transactions based on the size and direction of the largest-volume transaction, therefore altering its market price and benefiting from a trading advantage.”
The separation of building blocks from proposing blocks provides the mechanism to segregate these duties to help assure proposers don’t add their own transactions.
However, it is a common misconception that miners find and extract all MEV. Under proof-of-work, much of the MEV is extracted by MEV Searchers. These Searchers play a key and profitable role. They monitor public transaction pools (mempools) to find profitable trading opportunities, then create the transactions to exploit them. Miners are incentivized to order the transaction according to the incentives (Priority Fee, also known as the “miner tip”) set by these Searchers.
Under proof-of-work, MEV Searcher bots will search for untapped profits and incentive builders to include the Searchers transactions in the next block. Searchers will still search but the builders can decide to include only blocks that do no harm–open, public, non-extractive.
MEV is Not Insider Trading
Insider trading implies access to privileged information but mempool data is public and open. This information is available at over 2500 Ethereum nodes and can easily be monitored online through mempool explorers like https://explorer.blocknative.com/.
High-frequency traders in crypto, commodities, and stocks all take advantage of their ability to take advantage of temporal asymmetries to make profits. The MEV trader is able to react to this information rapidly in the time it takes to achieve consensus on a block, typically around 13 seconds on average. No material, nonpublic information that could substantially impact an investor’s decision to buy or sell is used in MEV.
Open, Public, Non-Extractive MEV Leads to Moderation and Self-Regulation
Recent MEV growth has led to the rise of a number of potential countermeasures including redesigning DEXs to mask transaction data and create fair ordering protocols. Another option is for wallets and dapps to identify potential MEV risks associated with transactions and alert users or even enable them to share in the MEV profits.
There is no question that unchecked profit-maximizing block auctions will cause harm to users. Just because they maximize MEV and are transparent does not mean auction marketplaces are necessarily fair. But increased regulation around MEV is not necessarily the answer.
The Ethereum Foundation and the community of users and developers are aware of the issues some types of MEV bring, which a lot of research is currently going into in order to find the best way to separate block building from block proposing. The Merge will bring a new economic class to Ethereum with different motivations than traditional miners. This has the potential to fundamentally change the landscape of MEV.
For example, some block proposers may only accept and propose blocks that do not include malicious MEV. These new auctions that enable competition on features other than simply max profit can reduce investor abuses and may even be self-regulated.
BIS says that regulatory bodies around the world need to establish whether value extraction by miners constitutes illegal activity. However, the decentralized nature of blockchains makes regulating blockchain technology untenable. We believe that regulating the code of conduct of the market participants under their jurisdiction is the only practical approach. ESG policies of some funds and firms will certainly evolve to prohibit investments that do not meet their ethical requirements.
Do Not Overreact
Decentralized finance enables efficiencies and financial inclusion opportunities that are impossible in centralized finance. It is important that government regulators engage with the crypto community so they do not overreact and impose strict regulation that stifles this innovation. The ethos of the web3 community will help guide self-regulation to minimize harm to individual investors as DeFi matures. Industry and government must engage to achieve a balance between self-control and investor regulation as the nature of money transforms.
John Jefferies is the chief marketing officer at Blocknative, an infrastructure provider.