Journey to the Dark Forest of MEV: Stage Two — Key Concepts to Understand Before Diving into MEV

This material was created by the MEV-X team for educational purposes. MEV-X is a research and commercial project created for the extraction of MEV, which aims to form a reliable scientific community and promote the fair distribution of the extracted MEV.

Welcome back to our series, “Journey to the Dark Forest of MEV” In Stage One, we explored the fundamental principles of blockchain technology. Now, as we venture deeper into the Dark Forest, it’s crucial to grasp several key concepts that underpin the world of Maximum Extractable Value. This stage will arm you with the knowledge necessary to understand and navigate MEV.

Key Concepts to Understand:

1. Transactions

A transaction in blockchain is a transfer of value or data between participants. This could involve sending cryptocurrency from one user to another, executing a smart contract, or recording any other type of data. Transactions are initiated by users, signed with their private keys, and then broadcasted to the network.

Components of a Transaction:

• Sender and Receiver Addresses: Identifying the parties involved in the transaction.
• Value: The amount of cryptocurrency being transferred.
• Gas Fee: The fee paid to miners or validators for processing the transaction. This is often crucial in determining the priority of the transaction.
• Data: Optional additional data, often used in smart contracts to trigger specific functions.

The Mempool:

Transactions are not instantly added to the blockchain. Instead, they are first collected into a pool of pending transactions known as the mempool. The mempool acts as a holding area where all transactions wait to be picked up by miners or validators for inclusion in the next block.

Importance of the Mempool:

1. Transaction Visibility: All pending transactions are visible in the mempool. This transparency allows for analysis and strategic planning.
2. Prioritization: Transactions with higher gas fees are typically prioritized for inclusion in the next block, as miners/validators are incentivized to maximize their earnings.
3. MEV Opportunities: Miners and bots analyze the mempool to identify profitable MEV strategies. By understanding the transactions waiting to be processed, they can plan actions like front-running, back-running, and sandwich attacks to maximize profits.

2. Blocks

Blocks are the fundamental building units of a blockchain. Each block contains a group of transactions, a timestamp, and a reference to the previous block, forming a chain. The process of creating a new block involves:

• Transaction Selection: Miners/validators choose transactions from the mempool.
• Transaction Ordering: The order in which transactions are included can impact MEV.
• Proof Mechanism: The block is validated through either Proof of Work (PoW) or Proof of Stake (PoS).
• Block Addition: Once validated, the block is added to the blockchain, becoming part of the permanent ledger.

The order of transactions within a block is crucial for MEV extraction. By rearranging transactions, miners can prioritize those that offer higher fees or strategic advantages, enabling tactics like front-running.

3. Miners and Validators

Miners and validators are the backbone of blockchain networks. They are responsible for validating transactions and adding them to the blockchain. Their roles and mechanisms vary between different consensus models, but their influence on transaction inclusion and ordering is central to MEV extraction.

Transaction Inclusion

Miners and validators decide which transactions to include in a block. This decision is influenced by various factors, primarily transaction fees. Higher fees incentivize these entities to prioritize certain transactions. However, the inclusion process can be strategically manipulated to maximize profits, a practice that forms the basis of many MEV strategies.

Transaction Ordering

The sequence of transactions within a block can significantly impact their outcomes and the potential profits for miners and validators. By reordering transactions, these entities can exploit opportunities such as arbitrage, front-running, and back-running. This manipulation is a key component of MEV, as it allows miners and validators to extract additional value from the transactions they process.

Proof of Work (PoW) Systems

In PoW systems, miners compete to solve complex cryptographic puzzles. The first miner to solve the puzzle gets to create the next block and is rewarded with newly minted cryptocurrency and transaction fees. This competitive nature drives miners to optimize their operations for profit.

Proof of Stake (PoS) Systems

In PoS systems, validators are chosen to create new blocks based on the amount of cryptocurrency they hold and are willing to “stake” as collateral. Validators are incentivized to act honestly through rewards and penalties.

4. Gas Fees

On platforms like Ethereum, users pay gas fees to execute transactions and smart contracts. These fees compensate miners or validators for their computational effort. The gas fee mechanism includes:

• Gas Price: The amount a user is willing to pay per unit of gas.
• Gas Limit: The maximum amount of gas a user is willing to use for a transaction.

Higher gas fees can incentivize miners to prioritize certain transactions. This dynamic is central to many MEV strategies, as users may offer higher fees to ensure their transactions are processed quickly or in a specific order.

5. Smart Contracts

Smart contracts are self-executing contracts with the terms directly written into code. They automatically enforce and execute agreements when predefined conditions are met. Key features include:

• Automation: Execution without the need for intermediaries.
• Transparency: Code and execution are visible on the blockchain.
• Immutability: Once deployed, the code cannot be altered.

MEV strategies often exploit the predictable nature of smart contracts. For instance, by observing pending contract executions in the mempool, bots can place advantageous transactions that capitalize on the contract’s outcome.

Conclusion

As we continue our journey into the Dark Forest of MEV, understanding these key concepts is essential. Blockchain technology’s transparency, decentralization, and immutability provide both opportunities and challenges in the realm of MEV. Armed with this knowledge, you’re better prepared to explore the advanced strategies and tactics that drive MEV extraction.

Stay ahead of the curve and keep up with the latest news and developments in blockchain technology with MEV-X:

Website | Twitter | Telegram | LinkedIn