Miners and validators play a critical role in selecting transactions to include in a block. Profit maximization is a significant motivator, leading to the emergence of practices such as Maximal Extractable Value (MEV).
Read on to learn what MEV is, how it works, and its impact on the cryptocurrency market.
What Is MEV?
The term Maximal Extractable Value (MEV) refers to the potential for miners to earn from validating a transaction by prioritizing the transaction based on its possibility of making them money.
Before the Ethereum ‘Merge,’ this strategy was called Miner Extractable Value. Under the current Proof of Stake model, where validators perform transaction validation, their strategy to prioritize profitable transactions is now termed Maximal Extractable Value.
Given the role of many blockchain networks in Decentralized Finance (DeFi), a variety of opportunities exist within these networks. Miners and validators can reorder, exclude, or include transactions to squeeze out extra value in addition to their standard rewards and gas fees by using MEV as a strategy.
How Does MEV Work?
Before getting added to a block, transactions stay in the mempool, waiting for miners or validators to process them.
Since blockchain networks are public and transparent, searchers utilize MEV bots to scour the network’s mempool for profit opportunities. Once identified, the profitable transactions receive priority in processing.
Miners (PoW networks) and validators (PoS networks) are block producers responsible for maintaining the integrity of transactions and ensuring the network’s continued functioning. Block producers execute the strategies of MEV searchers due to the high transaction fees they can earn.
Types of MEV in Crypto
There are three main types of MEV extraction in the cryptocurrency market.
Liquidations
In liquidations, searchers set up their bots to identify liquidation opportunities for DeFi loans’ collateral where users had deposited their digital assets as collateral for loans. Negative market movements lead to the collateral’s value dropping beyond a predetermined level, triggering liquidation. The transaction that triggers the liquidation receives a reward or fee. Once the bot identifies the opportunity, the searcher or block producer sets up their liquidation transaction to move to the top of the queue to claim the reward value.
Front-Running
The existing MEV opportunity here involves front-running a large buy order pending in the mempool. Once the searcher identifies the transaction’s profitability using an MEV bot, they replicate it with a higher gas fee to ensure validators on the network grant it transaction priority.
Arbitrage
The MEV opportunity in arbitrage occurs when there is a significant difference between the price of a digital asset across exchanges. A miner or validator can spot a pending arbitrage transaction and execute their own transaction first to profit from the price differential.
Impact of MEV on Crypto Market Participants
MEV strategies are only as effective as the existing market inefficiencies. Consequently, they work as identifiers of existing inefficiencies, pushing those affected to take steps to correct them.
An example of an inefficiency is speedy liquidations on DeFi lending protocols, which may deter lenders. Once the inefficiency is exposed, protocol developers can take steps to figure out the required changes to ensure all parties are protected.
Actions such as front-running increase the processing time of other transactions, leading to network delays and higher gas fees. This presents a larger problem regarding network integrity, where reordering gives better value for a block producer. There is a risk of the producer focusing on reordering based on MEV opportunities, leaving the network facing consensus instability.
On the other hand, MEV can also bring a positive effect to balancing out the price of tokens in different exchanges, especially when MEV traders participate in arbitrage trading, where they buy tokens at a low price and sell them at a higher price on another exchange. Such trading prompts exchanges to balance their pricing, benefiting their users.
MEV Mitigation and Transparency Efforts
Networks and DeFi applications have taken steps to reduce the effects of MEV on their networks and protocols.
One way is through bundling transactions on a network to be processed at the same price, which offers no MEV opportunities, as all transactions will have the same reward. Block producers would have to figure out the signed messages and identify the pool that will settle the trades in a bundle. Given that such identification is near impossible, users avoid the concerns associated with MEV strategies.
Platforms such as Uniswap have also taken steps to address MEV concerns. The platform applies an intra-block volatility threshold that determines the maximum allowed price deviation between two consecutive blocks. Transactions that exceed the threshold get reverted.
Final Words
Depending on its applications, MEV can have varying impacts. In some cases, it incentivizes developers to close the existing gaps in their protocols. In other cases, MEV helps balance market inefficiencies that present arbitrage opportunities.
Generally, MEV presents a problem in scenarios where block producers have control, which carries a potential for misuse. However, the industry has been proactive in MEV mitigation efforts, and determining their effectiveness will take time.
