Miner Extractable Value (MEV) 101: Why, What, and How
MEV, also referred to as Miner Extractable Value, is becoming a point of discussion among Ethereum developers and traders as DeFi continues to thrive on the Blockchain ecosystem.
Synonymous to a miner’s ability to decide where and when a transaction is placed on a block, Miner Extractable Value (MEV) is often used by miners to generate additional revenue on a block by re-ordering transactions in each block, in ways that are beneficial to them.
Miners use techniques like front-running, back-running, and sandwiching to exploit transactions on a block to earn more profits.
Let's see how Miner Extractable Value (MEV) works:
On a blockchain, a block is added to its chain only after the validators agree upon a given order of transactions and reach a consensus. However, the block is created by a single user (miner).
The user (miner) is in control of where they wish to place the transaction in a certain block. MEV allows miners to place the transaction in a block in a sequence of their choosing, where they can profit off of a transaction, while also asking for a higher gas fee.
Since validators mostly agree upon the block with a higher gas fee, the manipulated block is more likely to be added to the chain. Front-running, back-running, and sandwiching are some of the distinct ways that miners use to make money off MEV.
Let's look at some examples of how miners make money off of Front-running and Sandwiching.
Front-Running: Front-running simply refers to an event, where a miner places their own transaction in front of another transaction in a block, that helps them make a profit.
In the case of a transaction involving a huge sum on a DEX, the miners can sometimes predict the implications and future price swings. This helps them capitalize on the opportunity by placing their own transaction ahead and ‘Front-running’ their transactions.
This applies also in traditional finance, where the term originated. Let’s look at an interesting version of Front-running in traditional finance. Suppose a businessman asks a broker to buy him 200,000 shares of a company.
Now the broker knows that a trade of this volume is bound to inflate the price of the share, so before getting the shares for his client, the broker instead buys a certain number of shares for himself. Now as soon as the price of the share goes up, the broker sells the share to make a profit.
Recent studies have found that Front-Runners make millions in profits through MEV, and even compete with each other to make the most out of their opportunity. Front running has oftentimes become an expected tactic used by miners, as many believe that unless you are a front-running, you will eventually end up making a loss in mining cryptocurrency.
Sandwiching: Sandwiching is another technique that uses transaction sequencing in order to make a profit for the miner. It differs from Front-running in that the miner places the transaction in the middle of other transactions instead of placing it at the front.
Let’s considers a Decentralized Exchange (DEX) on top of Ethereum, where a huge transaction has caused slippage in price, bringing forth an opportunity to earn thousands of dollars in profit.
A miner who recognizes the transaction before it is executed can ‘sandwich’ the trade between their own buying and selling transactions. This inflates the gas fee of the transaction, allowing the miner to make an instant profit at no additional cost.
Blockchains that rely heavily on smart contracts such as Ethereum are inherently plagued by Miner Extractable Value (MEV); however, those that do not support complex smart contracts are not privy to MEV either. Bitcoin, for instance, is also ‘technically’ vulnerable to MEV, though not as much as Ethereum.
This is also because the MEV that accumulates on a Blockchain over time is proportional to the complexity of the given chain. Experts also believe that Proof of Work-based Blockchain protocols destabilize consensus, and threaten the integrity of the protocol.
Protocols such as Ethereum rely heavily on smart contracts, and the complexity of smart contracts on Proof of Work-based Blockchain protocols is quite high. Moreover, with DeFi flourishing in the various Blockchain ecosystems, the complexity of smart contracts isn’t likely to go down anytime soon.
MEV thrives on the same complexity and hence is more prevalent in smart contract-based Blockchains. Such protocols, therefore, cannot mitigate MEV incentives without changing their underlying architecture.
MEV is an inherent property of blockchain protocols, and cannot be eradicated without the creation of off-chain markets. For instance, if all the transaction fees were equal, miners would negotiate with traders to pay the transaction priority out of the protocol. Most other cases would lead to a similar dilemma.
One way of eradicating transaction sequencing for MEV is to enhance the application designs to minimize incentives around such price manipulations. While this is a viable proposition, the current research around MEV is focused on eliminating the ability to destabilize the consensus by making it more costly and difficult.
Blockchains that employ the Proof of Stake consensus model could essentially slash incentives for validators who attempt re-sequencing; however, the MEV profit can always be greater than the reduced rewards.