A Succinct Primer on MEV & Flashbots

As a pre-read for my next article on "The Flashy Elephant in the Room: Business Models in MEV"

What is MEV

MEV stands for Maximal Extractable Value in the PoS context (previously “Miner Extractable Value” in the PoW era). It refers to the process for validators to maximize the value that can be extracted from block production in excess of the standard block reward and gas fees by including, excluding, and changing the order of transactions in a block¹. Where there are on-chain price quotes, there will be MEV to varying degrees on all chains.

Based on Grand View Research’s projection, Defi market size is expected to grow at a CAGR of 42.5% from 2022 to 2030 to become a $230B industry by 2030. According to Dune analytics, Ethereum validators and searchers have reaped close to $700M in gross profit from MEV to date based on ETH’s TVL of about $30B currently, and in aggregate with the MEV extracted from other non-Ethereum chains, the total MEV market today easily exceeds $1B.

How it Works: Who’s doing What?

1. User: Anyone who would like to express and submit intent to change the state of the blockchain.

2. Wallet / Application: The user interface that translates user intent into a blockchain transaction.

3. Searcher: Arbitrage seekers who send transactions to block builders through public or private peer-to-peer transaction pools

4. Builder: Block builders are highly specialized actors who construct blocks from transaction orderflow (public transactions, bundles, private transactions, etc). Profits to builder = Gas fee from searcher - bids paid to proposer

5. Relay: Trusted marketplace-like data availability layer to connect builders and proposers, from which builders choose the highest bids. Relay will be displaced by PBS stage 3 implementation. It's worth noting that Relay is where a lot of the censorship can happen (Flashbots is OFAC compliant) & has opacity around data. Flashbot is also the only relay that's permissionless (hence the high market share) whereas other relay needs to be whitelisted.

   Profits: in Private Order Flow, relays can monetize by selling exclusive order flow to builders or by taking a cut of private MEV auctions. Relays can incentivize transaction originators to use them by rebating users

6. Validator/Proposer: a block proposer is a validator that has been pseudorandomly selected to build a block for a given slot in an epoch (there are 32 slots per epoch). Profits = gas bribe + block reward

Examples of MEV

·       Front running (Sandwich attack)

·       Back running (DEX Arbitrage, liquidations from collateral)

·       NFT MEV

Why is it Important?

THE POSITIVE

MEV has an important role in the defi ecosystem

a)      Maximize the efficiency of defi markets by utilizing protocols’ economic incentive to restore market equilibrium & price parity. MEV can be beneficial to ensure the robustness of the defi ecosystem, for example, by

a.      ensuring DEX prices are in line with those of CEXs

b.      keeping algorithmic stable coin at peg

c.      eliminate bad debt via liquidation

b)     Boost block reward earnings for validators: at the moment, 37% of the block reward that validators earn are from MEV boost (per the Toni Wahrstatter’s MEV dashboard). In other words, today, MEV increase validators’ block reward earnings by approx. ~60%, calculated from (37/(1-37) = about 60%).

THE NEGATIVE

Externalities from creating artificial scarcity of block space because of bidding war from PGA bot operators. Specifically, adverse effects are

a)     To users

• High/overpaid and volatile gas price from Priority Gas Auctions (PGA)

• Network congestion

• Susceptibility to attacks such as Sandwich attack, Frontrunning, etc.

b)     To validators

• Unnecessary P2P network load

• Wasted block space from failed transactions

c)      To the Ethereum Ecosystem

Excessive MEV posts a significant centralization risk to the Ethereum ecosystem because it gives validators strong incentives to vertically integrate with searchers. There are two ways to extract MEVs for validators²:

1. (Pre-Flashbots) They capture MEV themselves: professional validators are much more efficient in maximizing MEV, leading strong incentives to vertically integrate (validator = researcher)

2. They sell re-ordering rights to others: where Flashbots and Ethereum’s upcoming PBS (Proposer-Builder Separation comes in)

How Flashbots Works

There are mainly three ways in which MEV is done:

1.      Spam war

if a transaction is ordered randomly, searchers are then incentivized to use bots to spam the network in hope to win the arbitrage bid (happened to Solana)

2.      Latency war

For consensus that disables transaction re-ordering and adopts a FIFO method, arbitrage searchers are incentivized to collocate to where validators are or run their own nodes, similar to how high-frequency traders on Wall Street collocate to where servers are

3.      (Flashbots) Off-chain auction

This is Flashbots’ approach by increasing competition & shedding light into the “dark forest” by creating an open marketplace. This way validators can outsource block construction for builders to supply the highest value block for the validator/proposer to include on-chain.

Flashbots alleviates the inflated gas fee for users from PGA by moving the bidding war from mempool to off-chain on Flashbots. It created a permissionless, fair, and transparent marketplace for searchers, block builders, and validators to privately communicate their bid and granular transaction order preference without paying for failed bids.

Where Flashbots Excel

Source: Flashbots Transparency Report

Since Flashbots’ initial release, it reached immediate product-market fit with 87% of block proposers outsourcing their block construction to Flashbots today, according to Flashbots Transparency Report. As the undisputed pioneer and core contributor in the Ethereum ecosystem to solve the MEV problem, the Flashbots team has major advantages on multiple fronts: 

1. First mover advantage & clear evidence of product-market fit: as the first and dominant MEV marketplace, both MEV-Geth and MEV-boost are used by close to 90% of ETH validators

2. Talent monopoly: Flashbots’ academic roots and success to date help it attract the brightest minds in the space

3. Brand equity: as the premium public good research and development institute trusted by validators

4. Adaptive & strong team: from MEV-explorer to MEV-boost, to Flashbots-protect, to the current product SUAVE to decentralized block builders, the Flashbots team has demonstrated an impressive ability to gauge market needs & ship products swiftly per customer demand

Flashbots Product Offerings³ to Date

1. Flashbots Auction: Marketplace for transaction ordering including the Flashbots Relay and MEV-Geth.

2. MEV-Boost: An out-of-protocol implementation of proposer-builder separation (PBS) for proof-of-stake Ethereum to allow anyone to become a block builder.

3. Flashbots Protect: A RPC endpoint for protection against frontrunning and failed transactions.

4. Flashbots Data: Tools and dashboards to improve the transparency of MEV activity on Ethereum and the Flashbots Auction

5. MEV Inspector: Finds validator payments, tokens transfers and profit, swaps and arbitrages, and more

6. SUAVE (the current product that Flashbots are raising for): A new EVM-compatible blockchain as a plug-and-play private mempool and decentralized block builder for all blockchains

Citation

¹ Maximal Extractable Value by Eth Foundation

² Extractable Value by Amber Group

³ Flashbots Offerings by Flashbots