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What is MEV in Crypto?

Posted January 3, 2024

What is Maximal Extractable Value (MEV) in Crypto?

Hang around the crypto trading world long enough, and you’ll likely come across the term “maximal extractable value,” sometimes rendered “miner extractable value.” Like many terms in the crypto world, it’s a new one; MEV didn’t really originate until 2019, and has only become widespread in the past couple of years. So what is MEV in crypto?

Here at Plexus, we try not to get too technical on the blog. But the growing popularity of MEV, and its significance for crypto participants from traders to investors to DEX participants, makes it a topic worthy of a more detailed discussion.

Maximal Extractable Value (MEV) in the crypto world refers to the maximum potential profit a miner or a network participant can extract from block production and transaction ordering. It has become an emerging topic in the field of blockchain technology, particularly in the context of decentralized finance (DeFi) and Ethereum. MEV is a concept that has grown in importance as users and developers have come to understand its potential impact on the functioning and security of decentralized networks.

Maximal Extractable Value vs. Miner Extractable Value

MEV is closely related to the idea of miner extractable value, which refers to the potential profits that miners can gain by intentionally including or excluding certain transactions from the blocks they create, thus increasing the value of the block rewards the miners earn. As the value of transactions on blockchain networks has increased, so too has the potential profit that miners can extract. In some cases, miners may engage in activities such as front-running, where they anticipate and exploit the potential profit from a pending transaction, or sandwich attacks, where they manipulate the order of transactions to their advantage.

In the context of DeFi

In the context of DeFi, MEV has become particularly relevant due to the complex and interconnected nature of decentralized financial applications. In DeFi, users can interact with smart contracts for trading, lending, and other financial activities. As these transactions are recorded on the blockchain, there are opportunities for miners to extract value by manipulating the order of transactions or exploiting vulnerabilities in the smart contracts.

To better understand how MEV works, let’s consider an example. Suppose there are two traders, Alice and Bob, who are both trying to execute a trade on a decentralized exchange. Alice wants to buy a certain crypto asset, while Bob wants to sell the same asset. They both submit their transactions to the blockchain, and miners have the ability to determine the order in which these transactions are included in a block.

In this scenario, a miner could potentially engage in front-running by prioritizing Bob’s sell order before including Alice’s buy order. By doing so, the miner could benefit from the price movement caused by Bob’s sell order before executing Alice’s buy order. This would allow the miner to extract value from the trade at the expense of Alice and Bob.

Implications for security and reliability

MEV also has implications for the security and reliability of blockchain networks. As miners have the ability to manipulate the order of transactions and potentially profit from doing so, there is a risk that this behaviour could undermine the trust and integrity of the network. Additionally, MEV can create an uneven playing field for network participants, as the potential for profit extraction may incentivize miners to prioritize certain transactions over others, leading to a lack of fairness and transparency.

In response to the growing concerns around MEV, there have been efforts to develop solutions to mitigate its impact on decentralized networks. One such approach is the introduction of MEV auctions, which aim to create a more transparent and fair mechanism for miners to compete for MEV opportunities. Through MEV auctions, miners can bid for the right to include and prioritize transactions, thereby creating a more competitive and market-driven approach to MEV extraction.

Another potential solution to address MEV is the development of protocols and technologies that seek to minimize the opportunities for MEV. For example, the use of decentralized order execution or the implementation of privacy-preserving techniques can make transaction ordering less predictable and exploitable.

Benefits of MEV

At its core, MEV is a product of the decentralized nature of blockchain technology. Unlike traditional financial systems, where a central authority determines the order of transactions, blockchain transactions are included in blocks based on the rules set by the protocol. This opens up the possibility for miners to engage in what is essentially a form of front-running, where they can prioritize certain transactions over others to their advantage.

One of the most common examples of MEV is the front-running of decentralized finance (DeFi) transactions. In DeFi, users can engage in various financial activities, such as trading, lending, and borrowing, without the need for intermediaries. However, this also means that the execution of these transactions is public and can be observed by miners. Miners can take advantage of this transparency by reordering transactions in a way that allows them to profit from the price movements that occur as a result of the transactions.

Another example of MEV is the manipulation of blockchain consensus mechanisms. In proof-of-work blockchains, such as Bitcoin and Ethereum (formerly), miners compete to solve complex mathematical problems in order to validate transactions and add them to the blockchain. This process involves selecting transactions to include in a block and determining the order in which they are included.

By controlling the order of pending transactions, miners (or validators in proof-of-stake) can reap two primary benefits:

Financial gain

By front-running transactions or manipulating block order, miners can profit from price disparities and market movements. This can be particularly lucrative in the highly volatile world of cryptocurrency, where small price movements can result in significant profits.

Competitive advantage

By being able to strategically include and order transactions, miners can gain more control over the network, potentially leading to increased mining rewards and influence in the blockchain ecosystem. This can be done by front-running transactions, inserting their own transactions, or even censoring certain transactions altogether.

MEV, Crypto, & Decentralized Exchanges

One of the most common examples of MEV is front-running. This occurs when a miner observes a pending transaction in a block and quickly submits a transaction of their own with a higher fee to get ahead of the original transaction. As a result, the miner can profit from the price movement caused by the initial transaction, at the expense of the original user. This practice is especially prevalent in decentralized finance, where users often interact with smart contracts that execute trades or provide liquidity.

Decentralized exchanges (DEXs) are particularly prone to MEV, as they rely on on-chain order books and automated market-making algorithms to facilitate trading. When a transaction is submitted to a DEX, it can be observed by traders looking for arbitrage opportunities.

To illustrate this, let’s consider a hypothetical scenario on a DEX. User A submits a trade to buy a specific token at a certain price. Before this trade is processed, the transaction rests in a “mempool”, a publicly-viewable ledger of pending transactions. There, a miner observes the pending transaction and quickly submits a trade to purchase the same token at a slightly higher price. The miner’s trade is prioritized, and the price of the token increases before User A’s trade is executed, leaving them with less of the token than expected. In this case, the miner has extracted value from the order of transactions, to the detriment of User A.

Impact of MEV on crypto networks

The impact of MEV on DEXs extends beyond individual users to the overall efficiency and fairness of the ecosystem. As MEV becomes more prevalent, users may become hesitant to interact with DEXs, leading to decreased liquidity and overall market efficiency. Additionally, MEV can exacerbate the existing challenges of front-running, slippage, and price manipulation in decentralized trading environments.

Despite the challenges posed by MEV practices, the impact is complicated. Increased arbitrage opportunities are just that – opportunities for savvy network participants. MEV is increasingly applied to more than just mining situations; there are opportunities for MEV with liquidation fees on lending protocols and transaction fees in crypto networks as well.

At the same time, there are ongoing efforts to control the impact of MEV on DEXs and other DeFi applications. One proposed solution is the integration of MEV protection mechanisms directly into the protocol layer. For example, the concept of “fair sequencing” aims to establish a fair and transparent process for ordering and executing transactions, regardless of miners’ actions. This could potentially limit the ability of miners to manipulate transaction order and extract value from the system.

As blockchain networks continue to evolve, it will be crucial to address the vulnerabilities associated with MEV and explore innovative solutions to ensure fair and efficient trading environments.

Potential Issues with MEV & DEXs

Another approach to address the potential issues with MEV in DEXs is the implementation of governance mechanisms and community-driven initiatives. By empowering users to have a say in the governance of DEXs, it is possible to establish rules and regulations that can help prevent the abuse of MEV and promote fairness and transparency in the decentralized exchange ecosystem.

It is also important for regulators and industry stakeholders to work together to address the potential issues with MEV in crypto and DEXs. Through collaboration and the implementation of regulatory frameworks, it is possible to establish guidelines and best practices that can help mitigate the negative impacts of MEV and ensure the integrity of the decentralized finance ecosystem.

In conclusion, while MEV has brought significant benefits to the crypto industry, particularly in the context of decentralized exchanges, it is important to recognize and address the potential issues that may arise from its use. By implementing MEV-resistant protocols, fostering community-driven governance, and working with regulators, it is possible to mitigate the negative impacts of MEV and ensure the fairness and integrity of DEXs in the decentralized finance ecosystem.

MEV, HFT, and evolving crypto trading

Increasingly, MEV is a trading strategy used by high frequency traders (HFTs) to capture profits from arbitrage and other inefficiencies in the cryptocurrency markets. It involves exploiting momentary price discrepancies between different exchanges, or between the same exchange’s spot market and futures market. Through algorithms that scan for discrepancies between different order books, HFTs can quickly execute trades at a profit.

MEV has become increasingly popular in the crypto industry as the markets mature and technology advances. With HFTs looking to capitalize on price discrepancies as soon as they arise, it is important for traders to stay up-to-date with evolving trading strategies and technologies in order to remain competitive.

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