MEV Supply Chain: Blockchain Infrastructure Providers Benefiting from the Emergence of Real-World Assets

OVNI Capital is a Paris-based first-check venture capital firm committed to aliens redefining global markets. A big thank you to Daniel Jean, Venture Partner @ Taisu, who co-wrote this article with us. At OVNI, we always tap into our network, trying to team up with the best tech experts. Working with Daniel on this has been a blast.

Did you ever wonder how your favorite Decentralized Finance (DeFi) applications and on-chain protocols keep running and being accessible 24/7? It’s largely thanks to Infrastructure providers. These so-called nodes, and validator nodes, are respectively responsible for keeping a copy of public ledgers (e.g., blockchains) and validating every operation that is submitted (token exchanges, smart contract¹ interactions, etc.) to a blockchain. Given their critical positioning, infrastructure providers play a major role in the liveness and safety of blockchain Decentralized Applications (DApps)².

Originally discovered by an anonymous developer in 2014, it was only in 2019, that the Ethereum ecosystem started to witness ‘unusual trading activities’ — arbitrage bots (we’ll refer to them as searchers in this article), started to monitor pending operations⁴, from Ethereum mempool, in an attempt to exploit profitable opportunities created by them. Phil Daian was the first to coin this very opportunistic behavior as MEV, or Miner Extractable Value, in his research paper.

MEV historically refers to the profits validators (mostly miners at its inception) can generate from reordering, censoring, or front-running transactions on a blockchain. The MEV market has exploded over the last three years along with the growth of DeFi, generating over $1 billion in revenue for Ethereum miners in 2021 alone.

The momentum in this market is staggering. As more DApps, DEXs⁵, and protocols launch on different chains, the potential for MEV profits is growing. Besides this growth, the space has professionalized, to structure the MEV toward a structured Supply Chain, welcoming specialized actors, playing different roles in this emerging value chain:

• Searchers (aka arbitrageurs) have armies of bots, algorithms, and traders creating the most sophisticated strategies to capitalize on every arbitrage opportunity and price discrepancy.
• Blockbuilders (specialized node infrastructure) have emerged as cutting hedge actors, capable of creating the most profitable blocks for Validators, thanks to their proprietary sorting/optimization algorithms.

On users’ hand, this might lead to slower, and trickier operation settlement and execution uncertainty — front/back-run transactions, censored operations, and lots of money being lost behind the scenes.

The risks are real. As the MEV market balloons, concerns over the centralization of blockbuilders, the emergence of private networks, and market manipulations are mounting. There’s a possibility that MEV could undermine the decentralized nature of blockchains if left unchecked. The future of this market remains uncertain, but one thing is clear — MEV is a big business opportunity.

Quick Definitions

MEV (Maximal Extractable Value): Previously known as Miner Extractable Value (when Ethereum were a Proof of Work blockchain). It is the maximum profit that can be made by including, excluding, changing the order of transactions in blocks, and arbitraging (front/back-run, sandwich attacks, etc.) operations in a mempool.
RWAs (Real World Assets): designates any assets, being physical, or digital, of which the value on a blockchain, stems from their existence outside — in the “real world”.
Blockchain Infrastructure Providers: any computing infrastructure that is responsible for playing a role in a blockchain (node, validation node, etc.)
Peer-to-peer networks: a group of computers, each of them being a node and sharing information, files within the group.

I. Real-World Assets’ state of the art

The tokenization of real-world assets (RWAs) has emerged as the next narrative of the bull market. From real estate and the digitization of financial assets to the rise of tokenized artworks, RWAs have experienced a significant growth. This growth is primarily facilitated by blockchain’s capability to enable the fractionalization of assets and provide trustless, secure registration, monitoring, and exchanges of tokenized asset fragments. Ultimately, it has the potential to make liquid assets considered as illiquid in traditional finance. Fundamentally, the tokenization of RWAs transforms the value and ownership of tangible assets, making their digital representations tradable and transferable.

The integration of on-chain RWAs addresses various existing challenges, including:

• The opacity of the traditional financial ecosystem (Slow settlement processes)
• High transaction costs as a consequence of the plethora of intermediaries involved
• Weak monitoring

In the past two years, companies such as Ondo Finance, Mapple, or Centrifuge have started to offer tokenized RWAs to B2B clients leading to a surge in on-chain volumes. Examining these volumes, here are various application fields of RWAs:

• Tokenized Treasuries
• Lending/Borrowing
• Private Credit
• Real Estate
• Stable Tokens (fiat/commodity-based)
• Equity/Financial (exotic/vanilla) Contracts
• Backed Collectibles/NFTs

Market Mapping by Galaxy

The recent surge in institutional interest aligns with the shift from isolated enterprise blockchains to more interoperable tokenization trials on public networks and protocols. Major institutions such as Goldman Sachs or Franklin Templeton, along with consortiums of actors, are spearheading institutional use cases.

In terms of technology, as the cryptocurrency market matures, there’s a recognition that specific standards must be established to meet the requirements of RWAs and ensure compliance with existing regulatory frameworks. The recent introduction of novel token standards, such as ERC 3643, provides an openly accessible set of smart contracts crafted for creating, managing, and transferring tokens. This framework is well-suited for tokenized assets requiring advanced security controls.

II. The MEV rationale

In blockchain softwares, validators (or miners) serve as securing entities, ensuring the validation of on-chain operations and maintaining the network’s liveness by creating blocks.

It is worth mentioning that there is no theoretical guarantee that an initiated operation will be executed exactly as submitted by a user or any arbitrary initiator. This is because block producers (validators and block builders) select operations from the public mempool, arrange them, and include them according to their preferences. By default, block producers often order operations based on the highest operation fees to maximize their profits — operations require a minimum amount of fees, depending on their complexity, and their subsequent execution time. Consequently, block producers can exploit their advantageous positioning to unilaterally reorder operations, creating what is known as Maximal Extractable Value.

To illustrate such a phenomenon, consider an arbitrage opportunity arising on a decentralized exchange. Two possible outcomes may occur:

1. Searchers notice the opportunity and adjust their operation fees to be the first to include their bundle of transactions⁶ in a block, thus profiting from the opportunity.
2. Block producers replicate the searcher’s trade, censor its operation, and execute it themselves.

In cases where block producers choose not to exploit the opportunity, searchers may compete, creating a bidding market where they aggressively outbid each other to win the bid, eventually boosting block producers’ revenue.

Currently, MEV is mostly associated with searchers who significantly influence the order of operations in a block by submitting complex bundles of transactions and modifying the operation fees paid to block producers. Validators are the primary beneficiaries of MEV while still performing the same validation duties.

Common types of MEV include:

• Front-running: Involves adjusting the fee to prioritize an operation to be first in the execution queue, ahead of publicly known operations from the mempool.
• DEX Arbitrage: The most prevalent form of MEV, where bots engage in arbitrage between various decentralized exchanges, capitalizing on price discrepancies.
• Back-running: Intentionally ordering an operation after a publicly known one (e.g., back-running a DEX token listing operation to be the first to buy a token).
• Sandwich: Combines both front-running and back-running operations.
• Time-bandit: A retroactively executed attack where block producers reorder blocks created in the past to capture MEV opportunities. This can lead to destabilizing the consensus.

Optimally, MEV contributes to enhancing the efficiency of DeFi markets by creating financial incentives to address price inconsistencies or discrepancies. Still, MEV also poses risks to the network consensus, especially when unexpected attacks like Time-bandit occur.

III. The Growth of Real-World Assets on Blockchains Driving Transaction Volumes

a) Surging On-Chain Transaction Activity

The acceleration of real-world assets tokenization on public blockchains is driving an increase in on-chain transaction volumes. As more people buy, sell, and trade RWAs on-chain, the number of transactions will skyrocket.

Since their inception, digital asset tokenization hasn’t significantly taken off, the highest volumes being still dominated by stablecoins and NFTs. This is nonetheless fundamentally changing, as we witness an increase of interest, toward a momentum among financial institutions, retail users, as well as institutional investors.

Different reasons may explain this recent surge in interest. Higher interest rates encourage tokenization use cases as a hedge against market volatility, certain classes of real-world assets suffering from limited liquidity and accessibility become openly tradable on-chain, and potential long-term cost reduction becomes an appealing factor for world governments and regulators. Hence, sovereign bonds, money market funds, and repurchase agreements are increasingly being offered, benefiting from enhanced liquidity, lower entry barriers and transferability restrictions, and assets’ divisibility, thanks to their tokenization.

b) Creation of New MEV Opportunities and their Mitigation

This influx of new on-chain activity presents an opportunity for arbitragers, market makers, and infrastructure providers (Block builders, Validators) to capitalize on inefficiencies, price discrepancies, and transaction volume. While searchers constantly monitor mempools and chains for arbitrage opportunities, looking to take advantage of users’ activity; their trading activity, when optimal, allows market makers to provide liquidity to the market, tightening spreads and stabilizing prices.

Infrastructure providers are positioned to be the biggest winners, as the more on-chain activity and volume increase, the more blocks tend to be profitable — infrastructure providers validating and including hundreds of complex operations in their blocks.

Incidently, some forms of arbitrage, such as front-running, or sandwich attacks are considered predatory. Arbitrageurs monitor pending transactions in the mempool for large orders and trade against initiating parties, harming liquidity providers and traders. Solutions like Flashbots, created a suite of tools to mitigate MEV. For instance, they implemented MEV-boost to manage private transactions until their delivery to selected validators, shielding them from front-runners. Other initiatives, such as MEV-Blocker tends to redistribute MEV to end users who create arbitrage opportunities for searchers.

Blockchain researchers are constantly seeking to implement strategies to curb malicious MEV and protect users while still allowing beneficial arbitrage. Some solutions include:

• Cryptography: Using zero-knowledge proofs and ring signatures to hide transaction details from observers. Using timelock contracts to temporarily hide the payload of a transaction sent to a smart contract for a period of time greater than the time it takes to include the transaction in a block.
• Shared Sequencing: Involving L2 ⁷ solutions, it consists of structuring blocks, such that the top block space is intended for regular user transactions and offers cryptographic protection against bad MEV, while the Bottom block space is designed for block builders to carry out revenue-generating activities.
• Incentives: Providing validators incentives to include transactions that maximize welfare, not just MEV.

Validators and builders are incentivized to include the highest bidders, redistributing some profits to a broader range of actors. Solutions like this could make it simple for average users to participate in and benefit from MEV, rather than just the tech-savvy few.

Other options focus on limiting harmful MEV practices in the first place, such as front-running or censorship. For example, zero-knowledge proofs and other privacy-enhancing technologies (FHE) may make transactions opaque to MEV extractors, reducing their ability to manipulate order. Sequencing services can also help by obscuring the connection between transactions in a block, though MEV will likely find new vulnerabilities to exploit.

The growth of RWAs demonstrates the potential of public blockchains but also underlines the need to mitigate risks like predatory MEV. With the right solutions, blockchains can reduce these negative externalities, build trust in their networks, and achieve mainstream adoption. The future is bright for on-chain markets that get the balancing act right.

IV. The MEV Supply Chain Participants and Their Roles

When it comes to the MEV supply chain, there are several key participants involved and the roles they play. Let’s break down who’s who.

a) Block Builders: Entities that run semi-proprietary algorithms (improved versions of public validator code), and compete in the market to create the most profitable blocks, on behalf of validators. They accept operations from MEV searchers, run their engine to craft the most profitable blocks, and send these blocks to relayers.

b) Relayers: Intermediaries between block builders and validators (aka proposers). They allow validators to offer their block space, given they are the ones selected by the consensus layer to produce new blocks. These entities have been controversial in the past, notably due to censorship concerns — Blocks submitted being deliberately ignored. We can distinguish two main categories of relays: censoring ones (that comply with legal constraints, such as blacklisted contracts and addresses) and non-censoring ones (that doesn’t operate any filtering).

c) Searchers: Also known as arbitrageurs, they write proprietary code and program bots to identify MEV opportunities, by carefully monitoring the public mempool as well as private pools of operations, where they compete to submit their bundles.

d) Peer-to-peer private networks: Decentralized connections among nodes, ensuring secure, direct communication and data sharing with a focus on transactions’ privacy. As of today, up to 15% of Ethereum blocks included transactions come from private networks.

e) Users: You and me and anyone else transacting on the blockchain. Unfortunately, as the MEV supply chain currently functions, regular users are often left vulnerable to front-running, censorship, and unfair transaction reordering by extractors looking to profit from MEV. User-focused mitigation strategies aim to give users more control and protection over their transactions.

f) Validators / Proposers: They are responsible for verifying and proposing new blocks that will be added to the blockchain. Validators can choose the most profitable block from multiple relays.

g) Indirect participants: Applications, protocols, and DApps that generate operations, influence operational fees, and validators’ execution rewards. They have the power to mitigate MEV for end-users.

V. The Risks of MEV Centralization Across Chains and Domains

The centralization of MEV across chains and domains poses serious risks that could undermine the resilience and censorship resistance of public blockchains. As the MEV market matures, certain participants are well-positioned to dominate the supply chain.

Large staking pools and validators have a built-in advantage for capturing MEV on proof-of-stake blockchains like Ethereum 2.0. They have more opportunities to propose blocks, giving them more chances to include high-value / high-rewards MEV transactions. This concentration of power threatens decentralization and could allow a few major players to exert control over transaction ordering and block production.

The emergence of specialized actors also introduces risks. Block Builders who develop advanced software and optimization algorithms to maximize MEV extraction may gain control over a large portion of the MEV market. If builders start to collaborate or merge, it could lead to a highly centralized block-creation process dominated by a few powerful entities. Such a scenario poses a serious threat to censorship-resistance.

Cross-domain MEV, where transactions on one blockchain can be front-run or manipulated by actors on another chain, represents an emerging threat, made possible by new efficient bridging solutions. As blockchain ecosystems become increasingly interconnected, MEV extracted from one domain could be used to attack another, creating a ripple effect across chains. This could undermine the security and resilience of the entire blockchain industry if left unaddressed.

Mitigating these risks and preserving the blockchain Ethos will require a combination of social consensus, cryptographic solutions, and protocol-level changes. Raising awareness about the threats of MEV centralization and rallying community support for solutions is a first step. Technological fixes like single-slot finality, verifiable delay functions, and zero-knowledge proofs offer promising ways to mitigate the MEV at a protocol level. Smoothing MEV redistributions across validators, staking pools and retail users could also help decentralize the supply chain and balance such phenomena.

Protecting retail users is critical to enabling mainstream adoption. By proactively addressing centralization risks and finding the right trade-offs between security, decentralization, and MEV opportunity, blockchains can build a more robust, resilient infrastructure for users and developers alike.

VI. Real-World Assets tokenization creating new MEV opportunities and Boosting Infrastructure Providers’ rewards

Bringing real-world assets onto blockchain infrastructures offers numerous advantages. By bridging Traditional Finance with Decentralized primitives, it enhances liquidity provision, streamlines exchanges’ settlement processes, and dismantles existing financial silos. This solution against opaque and inefficient financial systems, characterized by unfair transaction fees and time-consuming processes, represents a significant step towards transparency and efficiency.

The recent surge in tokenizing tangible real-world assets presents a lucrative opportunity for MEV infrastructure providers, particularly benefiting block builders and validators. The strategic move of directly incorporating tangible assets into blockchain infrastructures aligns with the broader objectives of digitizing and decentralizing ownership. This shift is expected to create larger liquidity pools, a diverse range of tokens backed by real-world assets offered directly to retail users, more advanced arbitrage opportunities, and blocks that tend to be more profitable than ever before.

Tokenizing real-world assets opens up opportunities to amplify on-chain operations, leading to increased fee generation, a surge in transactions, and consequently, augmented revenue for MEV supply chain participants — block builders, validators, and searchers. It’s worth noting that MEV is already a billion-dollar market, and the value capture potential for actors in the supply chain is poised to exceed $100 billion in the near future.

Looking forward, the potential arising from RWA tokenization emerges as a pivotal development for these actors. It not only significantly enhances liquidity, creating a more seamless environment for asset exchange and trade, but also contributes to the overall expansion of blockchain market volumes.

Conclusion

In the world of blockchain infrastructure technologies, where RWAs meet the nascent MEV Supply Chain market, we are at a crossroads of new emerging risks. The MEV market, an already billion-dollar industry, relies on the intricate dance between various participants: traders, infrastructure providers, and users. Yet, with this growth opportunity comes threats to decentralization and monopolistic positions.

Mitigating these risks demands a holistic approach blending technology, social consensus, and protocol-level changes. Democratizing MEV access and minimizing its negative externalities suggest collaborative solutions, aligning with a user-centric approach across blockchain infrastructures.

Looking ahead, the combination of MEV and RWA tokenization foretells a future where blockchain not only expands but highly specializes in complex software infrastructures, requiring professional expertise. The prospect of MEV participants reaping rewards in the era of RWA tokenization underscores the creation of new revenue opportunities.

Navigating the MEV and RWA landscape requires a delicate balance — embracing blockchain’s transformative potential while vigilantly guarding against centralization pitfalls. The future hinges on a collective commitment to a resilient, decentralized, and inclusive blockchain ecosystem.

¹ Smart contract: a piece of code that executes predefined functions on the blockchain.
² DApps or Decentralized applications: a set of smart contracts running to offer use cases and solutions.
³ Mempool: a storage area within the blockchain node, where transactions initiated on the blockchain can be stored for a short period of time, until their validation.
⁴ Pending operation: an operation from the mempool, that is being treated, but not yet included in a block.
⁵ DEX or Decentralized Exchange: a DApp representing a peer-to-peer marketplace where transactions occur directly between end-users. It fosters financial transactions that aren’t officiated by banks, brokers, or any other intermediary.
⁶ Bundle of transactions: transactions that are grouped together and executed in the order they are provided. Often used by MEV searchers, they may contain other users’ pending transactions from the public mempool.
⁷ L2 or Layer-2: technology built on top of a base blockchain (a Layer-1 network) that helps to extend the capabilities (mainly the scalability) of the underlying base layer network.

Working on MEV use cases? Feel free to ping us thomas@ovni.vc & daniel@venture-partner.xyz