What is MEV?
For the uninitiated, maximum extractable value (MEV) refers to the various techniques used by market participants to capture additional value by exploiting price inefficiencies in blockchain transactions.
One simple form of MEV is called “transaction sniping.”
More recently, we have begun to see signs of this phenomenon in local Bitcoin meme pools with ordinal transactions: Without going into too much detail, currently on-chain transactions are done using pre-signed Bitcoin transactions (PSBTs).
The concept is simple: some user posts a photo on the marketplace and creates a transaction with details and the price they are willing to sell it for. You, the cat lover, can purchase this holy grail of cats by completing the transaction and adding your address, transaction fee and signature. The transaction is then broadcast and eventually settled on the Bitcoin network.
It’s easy?
That’s not it.
Cats are a hot commodity these days, and it looks like other cat lovers are vying for your prey. The open nature of this offer means that anyone can interfere with your purchase. This is because PSBT listings are auctions and not exclusive sales. All transactions in the memory pool associated with cats are open for bids. Bitcoin’s 10 minute block interval provides an opportunity for cat opportunists to “snipe” each other’s transactions to get a shot at the most valuable. Nothing is resolved until a transaction is made into a block.
This means that on-chain auctions are subject to the settlement times of the blockchain on which the payments occur, which can be particularly problematic for anyone with ambitions beyond buying and selling cat pictures.
What causes MEV?
Now, what’s so great about MEV? I mean, not everyone is outraged by a handful of DeGeneres competing over cat photos, right?
To answer this question, we have to tackle a whole new problem. This will be a bit of a journey into the world of shitcoins, but bear with us, I promise it will be worth it.
MEV is big business. To put it simply, MEV-Boost, the software that orchestrates the extraction of MEV on Ethereum, has grown to nearly 100,000 servers in just under two years. 500,000 ETH The reward is nearly $2 billion!
What drives this whole market is, of course, trading (i.e. diversion).
On-chain AMMs (Automated Market Makers) use a popular concept called liquidity pools to allow users to trade assets without relying on a centralized order book. Pools typically consist of a pair of assets, such as Ethereum and USDC.
When users want to exchange one asset for another, they interact with these liquidity pools. Each transaction adjusts the ratio of the two assets in the pool, affecting their relative prices. By removing centralized order books that must match buyers and sellers for every transaction, AMMs can be deployed as decentralized on-chain contracts.
Once a trading pair is created, any user can trade against or provide liquidity to the pool. Providing liquidity involves supplying one or both assets to the pool to maintain the right ratio. Imbalances create opportunities for market makers to arbitrage by buying cheaper assets from the pool and selling them at a higher price elsewhere, such as on a central exchange. This activity, along with the fees that liquidity providers (LPs) earn from trading activity, incentivize people to maintain liquidity in these markets.
For those of you who have heard of DeFi and Uniswap but have never looked into it in depth, here is the secret sauce: liquidity pools can be deployed to trade any asset and are extremely popular due to their permissionless nature. Upon closer inspection, we see that these exchanges are not fundamentally different from the cat markets we discussed earlier, they are just on-chain auctions.
As you can imagine, Ethereum’s architecture and additional programmability create a particularly ripe environment for auctions to be abused and manipulated.
Perhaps the most popular and intuitive is front-running. Note that transactions in AMMs are not settled instantly. Just like cat snipers monitor Bitcoin’s memory pools to find attractive trades, Ethereum has an army of financial mercenaries who watch diligently for any trading opportunity.
However, the ETH guys aren’t playing around on this one. This isn’t Saving Private Ryan, this is SEAL Team 6. They employ some sophisticated techniques to take advantage of the time lag between when a transaction is broadcast and when it is confirmed on the blockchain. As a result, front-runners can place their transactions ahead of the original trade and profit from the price fluctuations caused by their actions, which causes ordinary users to receive a worse price than expected. One of the worst manifestations of this is the practice of users sandwiching orders, which involves placing a buy order just before a user’s trade and a sell order just after, capturing the price difference at the expense of the original trader.
While these trends are controversial due to their impact on user experience, they are only a small part of the MEV economy. Largest source of MEVsis a fairly large difference, and generallyLosses and RebalancingSimply put, this is the inverse form of the pool arbitrage discussed above, with implications for liquidity providers.
When the prices of assets in a liquidity pool diverge from the price at which they were originally deposited, arbitrageurs step in to rebalance the pool to reflect global market prices. This rebalancing process leaves liquidity providers vulnerable to market fluctuations between blocks. Their exposure to stale prices makes them easy targets for traders with access to centralized order books. These traders often take advantage of price discrepancies to disadvantage the liquidity provider’s asset composition, reducing its overall value.
The situation is very serious and Recent Research Papers Regarding this matter:
Our main result is that for most of the largest Uniswap pools, which currently hold hundreds of millions of dollars, the revenue from fees is smaller than the arbitrageurs’ losses. This result raises the question of why LPs put capital into these pools.
While other factors such as hedging have helped larger operations mitigate these issues, the extreme circumstances described may have led to liquidity provision being consolidated among fewer entities.
Why do we care about Ethereum?
Great question, Anonymous! The reason I bring this up is because a lot of the recent conversation about Bitcoin’s MEV completely overlooks the fact that these systems do not exist in a technological vacuum. I understand that any new and unknown concept will invite skepticism, but many of the dynamics involved are now well understood. Viewing it through a strictly technological lens does us all a disservice.
We understand that various new proposals emerging to improve Bitcoin’s scripting capabilities could introduce further expressiveness to the protocol. We cannot rule out the possibility that these features combined could allow someone to build the on-chain equivalent of an AMM. It is clear that something on the scale of Ethereum would have a negative impact on Bitcoin’s decentralization. We know that MEV tends to encourage high specialization at the mining level. If you want to better understand the risks at hand, you can take a look at the good report compiled by Spiral developer Matt Corallo. Introduction It’s a hot topic.
Unfortunately, the most important aspect of this subject has been almost completely ignored by everyone at the table: MEV and all related systems are driven by economic incentives. Various parameters can significantly affect the viability of this activity.
The cat story illustrates how the interval between blocks plays an important role in the game theory of on-chain auctions. This theory is currently Documented Evidenceresearcher Generally agree Longer block times exacerbate the issues with MEV, which poses a major challenge for anyone looking to build an AMM system on top of the Bitcoin blockchain.
Is Bitcoin at Risk?
Comparing Bitcoin’s 10 minute block interval to Ethereum’s 12 seconds, it’s natural to wonder whether the settlement times required for proof-of-work security are compatible across all large on-chain auctions.
As the interval between Bitcoin blocks gets longer, liquidity providers (LPs) are exposed to stale prices for extended periods of time, making it impractical or irresponsible to deploy large amounts of capital. This delay increases the risk of front-running and other forms of MEV exploitation – an arbitrageur’s dream.
These observations suggest that even if on-chain Bitcoin transactions were technically possible, they may not be viable. Applications targeting this use case are increasingly optimizing for speed and efficiency, leaving little room for Bitcoin to be a competitive option. Capital allocators will likely avoid the risks associated with this architecture, and users will simply prefer a platform that better aligns with their interests.
This highlights the critical importance of economic considerations when assessing the risks and benefits of technical changes to the Bitcoin protocol. Don’t get me wrong: the buzz surrounding this conversation is being generated by economic interests eager to replicate MEV’s monetary flywheel on top of Bitcoin. Now that attitudes about innovation at the protocol level have changed, they see this situation as a billion-dollar opportunity to reuse a proven business model.
What many don’t understand is that Bitcoin’s slow but stable settlement process acts as a natural deterrent to predatory MEV activity. This is not a comprehensive study and further evaluation is needed to assess the MEV risk of layers built on the protocol. In the meantime, there are some pretty compelling reasons to believe that fears of Bitcoin’s MEV monster may be overblown. The delays inherent in Bitcoin’s transaction finality provide a unique form of protection, making it less susceptible to the same level of MEV abuse seen on faster chains such as Ethereum.
