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What Is MEV in Crypto?

Coinspeaker
What Is MEV in Crypto?

The rise of cryptocurrencies and blockchain technology has significantly enhanced traditional finance, enabling new ways of money exchange without the need for centralized intermediaries. However, these new decentralized ecosystems also pose challenges, such as maximal extractable value (MEV), which refers to various strategies through which validators or miners can manipulate the order and selection of transactions in a block to extract the maximum possible value.

In this guide, we will delve into what MEV is, how it works, the different types of value extraction strategies, and the debate on whether MEV is positive or negative for the cryptocurrency ecosystem. Additionally, we will examine how bots and traders exploit market inefficiencies to claim profits originally intended for other users.

What Is MEV About?

MEV, or maximal extractable value, refers to the maximum value that can be extracted by manipulating the order, inclusion, or exclusion of transactions within the blocks produced in a blockchain.

The central idea behind the MEV concept is that those with influence over block production in a blockchain (miners in proof of work or validators in proof of stake) have power over which transactions they include and in what order to maximize their benefits at the expense of other network participants.

The term “maximal extractable value” and the concept behind it were coined in 2019 by researcher Phil Daian and colleagues in an influential paper called “Flash Boys 2.0”.

Originally, they referred to the concept as “miner extractable value”, focusing on the role of miners in proof-of-work blockchains like Bitcoin (BTC) and Ethereum (ETH) before the merge.

However, with Ethereum’s transition to proof of stake, the term expanded to maximal extractable value, realizing that not only miners but also validators and other actors could influence the transaction order for their benefit.

While the idea behind MEV has existed since the early days of Bitcoin, it has gained increasing relevance and research interest with the DeFi industry explosion built on Ethereum in recent years.

The programmable nature of smart contracts on Ethereum offers a much broader range of opportunities for complex value extraction strategies compared to more limited chains like Bitcoin.

MEV Explained

MEV capitalizes on inherent latencies in blockchains and the competition among transactions for inclusion in new blocks. When a user sends a transaction, it is broadcast to the blockchain network and waits in the “mempool” for confirmation. The mempool is a queue of pending transactions that validators will use to construct new blocks.

Validators then select which transactions to take from the mempool and arrange them within the new blocks they produce.

They typically prioritize transactions with higher fees (gas fees) to maximize their income. However, validators have discretionary power over the final order and selection of transactions.

For example, validators can identify opportunities such as price differences for a token between different decentralized exchanges, and predictable liquidation events in loan protocols, among other market inefficiencies. By reordering transactions related to these events, they can ensure their transactions are executed first to extract the maximum value from these opportunities.

Notably, the role that MEV plays in the crypto ecosystem is controversial. For some, it is another manifestation of financial incentives to secure blockchain networks, similar to transaction fees or mining/validation rewards.

Meanwhile, for others, it introduces user experience problems, non-transparent costs, risks to network integrity, and decentralization. Mitigating MEV’s negative effects without losing its benefits is an active research topic.

Types of MEV in Crypto

There is a wide variety of strategies through which actors in crypto can extract value by exploiting their ability to influence the order and selection of transactions on blockchains. Here are some of the most common types of MEV:

  • Front-running. Front-running involves monitoring the mempool of pending transactions and identifying “attractive” transactions that could significantly impact the price/market. Once the attractive transaction is identified, an actor sends a similar transaction but pays a higher fee to ensure the transaction is processed before the original transaction in the next block. This way, they can buy/sell tokens before the original trade impacts prices, extracting value from that price change before it reaches the original user.
  • Sandwich attacks. Sandwich attacks combine front-running with another strategy called backrunning. In this case, not only is a transaction sent before the victim transaction, but another is also sent after it. So, buying occurs before the original exchange anticipating the price change, and then selling immediately after that exchange to profit from the price change in the opposite direction.
  • Arbitrage between exchanges. Another common strategy involves taking advantage of temporary price differences for the same crypto asset between centralized and decentralized exchanges. Basically, it consists of automating bots that buy the “cheap” asset on one exchange and then instantly sell at the higher price on the other exchange, generating a net profit.
  • Value extraction in liquidations. As decentralized lending protocols require collateral from borrowers, actors compete to liquidate undercollateralized positions first to claim the liquidation fee that the defaulting borrower must pay.

Is MEV Good or Bad?

Providing a definitive answer to whether MEV is inherently good or bad is a complex task, as there are valid arguments supporting both perspectives. The potential benefits of MEV are as follows:

  • Arbitrageurs keep token prices aligned across different decentralized exchanges.
  • Bots liquidating excessively leveraged positions quickly in decentralized lending protocols help maintain the solvency and proper functioning of these protocols.
  • It could be argued that MEV helps strengthen the security of proof-of-stake networks by introducing greater economic incentives for validators to compete in proposing and confirming new blocks.

Meanwhile, the risks and negative effects of MEV include the following:

  • Harms the user experience by causing greater slippage or higher network fees.
  • Incentivizes power concentration in validation, if large groups are more effective at extracting MEV.
  • MEV could promote potential instability in the consensus mechanism if reordering transactions becomes more lucrative than validating blocks honestly.

Taking all of this into consideration, blockchain researchers have not reached a consensus on whether MEV is purely detrimental to the ecosystem or if it is a necessary evil to continue providing greater security to blockchain networks.

Bottom Line

MEV is a manifestation of the broad financial incentives governing these new decentralized ecosystems. While some forms of MEV help maintain a more efficient DeFi ecosystem, and economic incentives strengthen the security of proof-of-stake networks, they also carry risks of power concentration, increased costs for users, and even potential threats to the stability of the consensus mechanism.

Therefore, mitigating the negative aspects of MEV without destroying its positive benefits is currently an active area of research within the crypto community. As the industry evolves, finding the right balance in these practices will be crucial to supporting both technical security and the social integrity of the ecosystem.

What Is MEV in Crypto?