The point of an entity supporting a blockchain network is to squeeze the maximum profits possible from the work that they contribute. Maximal Extractable Value (MEV) – also known as Miner Extractable Value – refers to the maximum profitability a validator can obtain by purposely including, excluding, and reordering transactions in a transaction block.
MEV is an important process of blockchain networks as block producers get to decide which transactions to include in a block and why. Block producers can also use certain strategies in order to further optimize their profits from MEV. Today’s article explains what is Maximal Extractable Value and how it works.
Maximal Extractable Value (MEV) represents the maximum amount of value that a block producer can obtain by reordering, inducing, or excluding transactions within a new transaction block. Miners handle MEV in Proof of Work (PoW) networks, while validators handle MEV in Proof of Stake (PoS) networks.
You can compare MEV to increasing the gas fee of your Ethereum transaction. You incentivise validators to include your transaction by increasing the fee that you pay for it. It’s the same as receiving better customer service in a restaurant when you leave a good tip.
Validators and miners – as block producers – have the right to decide which transactions will be found in a transaction block. They can prioritize certain transactions in order to extract the maximum value possible of the block. The process often harms most users as it introduces privileges to the system.
MEV has a large impact on user experience, especially considering that investors use DeFi protocols more and more. Estimations show that validators have extracted up to $687 million in MEV from the Ethereum network. As the graph below shows, the boom in MEV extraction aligns with crypto’s very own DeFi boom.
It’s worth noting that MEV is gained on top of transaction fees and block rewards. In some sense, MEV is an additional tax that investors, mostly those on Ethereum, face. It’s also why some believe that those automating bots that target MEV rewards are predatory in nature and harm the industry.
You must have a clear understanding of blockchain networks before learning how MEV works. A blockchain network is a digital ledger supported by anonymous participants that secure the network by confirming transactions. Miners represent this group in PoW blockchains, while validators represent the group in PoS blockchains.
Both miners and validators are block producers. They aggregate transactions into a singular transaction block that is then sent over to the decentralized ledger. The network then reaches consensus that the new block of transaction is part of the original blockchain history.
While blockchains utilize time stamping to prevent double-spending, block producers don’t order transactions in the same order they were submitted. Because each block contains a limited number of transactions, your transaction might not end up in the next transaction block due to MEV.
Block producers normally prioritize transactions that carry the highest gas price. However, that isn’t the rule. Producers might practice MEV and extract even more value for the transaction block by reordering transactions.
MEV extraction requires a certain level of skill, and also more resources. That’s why block producers might decide to employ other participants – such as searchers, relayers, and builders – for their cause.
Searchers are the most common MEV extractors. They’re also deemed to be the only entity capable of guaranteeing profitable MEV extraction.
The goal of a searcher is to run an automated process that searches blockchain networks for incoming MEV opportunities. Their algorithm also ensures that bots hunt down these transactions and take profit from them.
Validators receive a portion of the MEV rewards that searchers obtain. Searchers also tend to pay gas fees to validators in order to increase the chances of profitable transaction inclusion.
Keep in mind that searchers participate in a highly competitive sector. There are tons of MEV bots running the same algorithms and attempting to profitably arbitrage trade MEV opportunities. That’s why certain searchers drastically increase their gas fees for transaction inclusion.
The following section contains the most common examples of profitable MEV strategies. You will learn everything you need to know about strategies such as DEX arbitrage, liquidations, sandwich trading, and frontrunning.
Decentralized Exchange (DEX) arbitrage is the most popular MEV strategy in DeFi. Note that it is also the most competitive strategy due to how easy it is to automate.
For example, you might find that there is an arbitrage opportunity on two different DEXs for a single trading pair. You can profit from the price difference by buying the lower-price token and selling it on the higher-priced DEX. You can do so in a single atomic transaction and ensure arbitrage trading in a manner that carries zero risk.
DEX arbitrage is the same as normal arbitrage trading. The key difference is that the strategy takes place on decentralized trading platforms utilizing smart contracts. There’s no need to withdraw and deposit assets from one CEX to another – severely limiting the time it takes to execute the trade.
Lending protocols work on the basis of liquidations in the event that an investor taking out a loan does not have enough collateral. Market fluctuations can severely impact the worth of one’s collateral, leaving room for MEV extraction.
You can think of the strategy as infighting between whales. For example, whales can look at open interest (OI) and price levels to determine whether a big player has an underwater leveraged trading position. A whale can massively sell or buy the asset in order to liquidate the trader and profit from his loss.
The same can happen on decentralized lending protocols. Searchers can scour the blockchain for investors who provided collateral that are close to reaching their liquidation level. They can then attempt to liquidate the individual and claim their liquidation fee.
Sandwich trading is another remarkable MEV strategy that entails monitoring the mempool for large trades on DEXs.
Let’s say that you want to buy or sell an asset on a decentralized exchange. You will have a drastic impact on the asset’s price if you sell a huge chunk all at once. A searcher can figure out the price effect of that trade and execute a smaller order before the bigger trade.
However, the strategy is much riskier than normal DEX arbitrage. You will need to execute a smaller trade order together with the large one in the same instance. And you will have to follow that trade by instantly selling the larger order after the price increases due to price impact.
There are certain pros and cons to Maximal Extractable Value (MEV). The process carries both positive and negative effects. Keep in mind that MEV is not entirely negative for the blockchain industry or markets such as DeFi. The following two sections explain the pros and cons of MEV.
The decentralized nature of blockchain networks require 3rd-parties to ensure the proper functioning of such networks. For example, DEX protocols in DeFi require help from arbitrage traders for their trading pairs to reflect the most accurate price possible.
In some cases, DEXs do not use price oracles to stabilize their prices. They rely on arbitrage traders to shorten the price gap of their trading pairs. And in the case of lending protocols, searchers make sure that lenders get paid back when borrowers do not have enough collateral.
The negative effects of MEV are more severe. For example, sandwich trading has a noticeable effect on user experience. Sandwiched traders face terrible slippage and trade execution. This goes against the goal trading platform to minimize slippage by delivering enough liquidity.
Furthermore, certain MEV strategies have a terrible strain on blockchain networks. They increase gas prices and cause network congestion, ruining user experience.
Outside of DeFi, MEV can also have terrible effects on blockchain networks themselves. MEV can introduce problems such as consensus instability and blockchain reorganizations. Here is what Polygon recently did to combat blockchain reorgs.
The bottom line is that Maximal Extractable Value has much more negative effects on the blockchain industry than positive ones. MEV extraction leads to greed among searchers, miners, and validators. In return, users who participate in the blockchain network have a much worse user experience due to network congestion and other problems.
The good thing is that, as MEV strategies become easier, searchers and block producers will have more competition. More competition means that such strategies are less profitable and require more gas fees for successful MEV extraction.
The diminishing of MEV effectiveness is noticeable if you take a look again at the cumulative extracted MEV profit graph placed earlier in the article. The growth of MEV profits stall and no longer face the explosive growth that they once had. The data shows that MEV extrication is no longer profitable as it used to be – thus providing no further incentive to new searchers.
Unlike the case of block producers and transactions, developers always place user experience at the top of their priorities. That’s why the future will bring even more solutions for combating the negative effects of MEV extraction. That also means that network congestion will also diminish as developers introduce such solutions.
Want to learn more about blockchain networks? I recommend reading the following articles:
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