Oracle extractable value (OEV) refers to the subset of MEV that is related to oracle updates or their lack thereof. Current protocol designs result in poor execution for liquidated borrowers and arbitrage that extracts significant value from LPs, costing DeFi users millions of dollars and hampering adoption. For DeFi to achieve critical mass, addressing OEV is essential, and we must start looking at ways to improve oracles and the protocols that use them. Order flow auctions (OFAs) are a well accepted way of capturing and redirecting MEV to users, as seen by the use of MEV blocker and Flashbots mev-share.
OEV-Share is a novel OFA developed by API3DAO that caters specifically to OEV. OEV-Share auctions grant the winning bidder the exclusive right to perform a data feed update and collect the OEV associated with the transaction; operating as a sidecar alongside existing oracle updates to maintain liveness and security.
The Need for Oracle-Specific Order Flow Auctions
You may be wondering why an oracle needs a new type of OFA when there are existing options available?
Current OFA and oracle designs don’t allow for fair distribution of OEV auction proceeds to the dApp/users generating the OEV. This is because a data feed update transaction can be used to perform OEV on multiple dApps simultaneously, making it impossible to determine who deserves a share of the auction proceeds. An oracle-specific OFA can be designed to allow searchers to request order flow (OF), since oracles can generate OF on demand. This feature allows the oracle to sign data feed updates for use exclusively on specific applications, creating a method to direct auction proceeds directly to dApps where the OEV is generated.
Existing OFA designs also introduce latency to transaction propagation, which degrades the oracle performance. Searchers requesting OF through an OEV-specific OFA provides the benefit of reducing the latency impact of the auction. Moreover, demand for oracles is spread across many different blockchains, and an oracle-specific OFA can be accessible on any platform where the oracle services are available, as opposed to available OFA solutions that are currently only supporting Ethereum mainnet.
Benefits of OEV Auctions for DeFi Protocols
The majority of DeFi protocols that support over-collateralized borrowing pay a fixed percentage of liquidated collateral to MEV searchers to incentivize timely execution, but when loans are even somewhat valuable they end up significantly overpaying. In the last year borrowers on AAVE paid out around 14 million dollars on Ethereum mainnet alone to searchers and validators for liquidation execution. By returning OEV auction proceeds from liquidations to the affected dApp, most protocols can potentially reduce the penalty for liquidated borrowers by 5–10%, saving users millions. This will significantly improve the borrowing experience in DeFi by mitigating most of the potential loss, and should drive more borrowing to protocols that support OEV auctions. More borrowing will increase the returns for the lenders and thus attract more liquidity, creating a positive flywheel effect for the lending protocol.
Decentralized perpetual platforms that allow trading based on the price of an oracle are severely hamstrung by the inability for oracle prices to perfectly reflect off-chain prices due to block times, gas costs, and the nature of oracle-based exchanges not being used for price discovery. Oracle prices will always lag the off-chain price by some degree, and no matter how small this degree is, it will cause value to be extracted from LPs in the form of oracle latency arbitrage. Chainsight Analytics showed that arbitrage OEV extraction can amount to around 10% of GMX protocol profits. This has led to Synthetix and GMX, the two largest perpetual protocols, recently moving to new oracle solutions that minimize oracle latency arbitrage.
In the past perpetual protocols have primarily used high fees to offset losses for LPs from arbitrage. These high fees have had strong negative effects on adoption of their protocol because many users choose the lower fee environments of centralized exchanges instead. OEV auctions can serve as a way to direct value from arbitrage back to LPs of decentralized perps, enabling perpetual protocols to lower trading fees and attract more liquidity to compete with the user experience of centralized offerings.
OFAs will be a massive step forward to providing better execution and more value to DeFi users, with a focus on OEV being crucial to achieving this future.
