Miner Extractable Value (MEV): Are You Paying More for Using DEXs?

What is MEV?

Decentralized exchanges—DEXs have become popular among crypto users who prefer to maintain complete custody and control of their assets. As the number of DEX users grew, a subtle phenomenon known as Miner Extractable Value (MEV) emerged. MEV is the profit miners take for prioritizing—mostly through reordering certain transactions over others, increasing the cost traders have to pay for such transactions. 

Given that MEV is an activity that goes largely unnoticed on the user side of transactions, traders need to understand MEV, how it works, its implications, and ways to avoid it for better trades on DEXs. More detailed information about MEV is provided in subsequent parts of this article.

The Origin and Conceptualization of MEV

MEV dates back to the early days of DeFi protocols mostly on Ethereum. As users flooded DEXs during the DeFi Summer of 2020, miners found a clever way to manipulate the order of transactions for higher profits. The term “miner extractible value” got its name from miners prioritizing certain transactions over others to extract value from the network. 

The dynamics of MEV are, however, changing with Ethereums transition to proof-of-stake (PoS). In the PoS-based Ethereum 2.0, the concept of MEV evolves into Maximal Extractible Value as validators take the place of miners. The shift raised important questions such as whether validators will also exploit MEV to maximize gains leading to increased costs for traders. There are also concerns about how the MEV dynamics will impact Ethereum’s security, the measure to prevent abuses of MEV, and new DEX designs to reduce the impact of MEV.

Following the merge and transition to Ethereum proof-of-stake, validators’ incentive to maximize gains has led to significant costs for traders. The change in the extraction dynamics to tip-based priorities where high-tipped transactions take priority has also increased costs and network congestion. Ethereum developers are exploring the Mekka upgrade which includes an auction mechanism, a proposer and builder API to reduce the impact of MEV. DeFi protocols are also introducing new trading algorithms as measures against MEV.

MEV Extraction: The Searcher-Validator Dynamics

Validators are the primary beneficiaries of MEV in the current proof-of-stake landscape. Although there are also independent searchers chasing MEV opportunities. These searchers work like treasure hunters on Ethereum. 

When they strike gold, i.e. find an MEV opportunity, they automatically submit their transactions to validators on Ethereum. The thing is, searchers have to pay high fees to validators to add their transactions to the network. That is how validators reap a portion of MEV rewards without having to search for opportunities. The searcher-validator value-sharing activities on Ethereum raise another set of important questions that are crucial to understanding MEV. 

How do searchers detect profitable MEVs? They scan the network using complex MEV bots. Searchers also pay high fees to validators to prioritize their transactions. Validators may not actively participate in MEV extraction, but they benefit from searchers' efforts. In profit distribution, validators receive a smaller portion of MEV but it turns out to be significant since they have to do little to get it. Traders can avoid being extracted by timing and optimizing their transactions and setting low slippage whenever possible. 

The following are the biggest searchers on Ethereum:

• Front-runners: Bots that constantly watch mempools for profitable MEV opportunities.

• Flashbots: An independent project providing services that obscure validator-searcher dynamics from public memepools.

• Generalized front-runners: More advanced bots that use complex strategies, markets, and scripts to watch mempools for MEV opportunities.

• BlockBuilders: Tasked with transaction ordering and block-building.

Examples of MEV

Some of the best examples of MEV in the real world are:

DEX Arbitrage

 DEX arbitrage is one of the most common instances of MEV that involves exploiting price differences across various decentralized exchanges. Arbitrageurs often create bots that notice price differences on the same asset across decentralized exchanges and try to buy low on one exchange and sell high on the other exchange in one step using the bot. The strategy is a prime example of MEV in action that requires quick execution and precise price tracking. 

Liquidations

Liquidation is also a classic example of MEV where a buyer buys liquidated assets at a low price from lending protocols and sells the same in the open market at a higher price. Lending protocols often liquidate positions when they reach a certain level. 

Sandwich Trading

Sandwiching requires a high level of manipulation such as borrowing a flash loan to buy a high amount of tokens which creates buying pressure and increases the price of the token, followed by a small sell order for profit. The attack requires quick execution and timing. 

NFT MEV

The new MEV strategy requires identifying underpriced NFTs, buying these NFTs up to a high price point, and selling the same for profit. The strategy exploits inefficient DeFi assets to profit off price opportunities.

Challenges and Future Outlook

As MEV remains a crucial part of DeFi's future, it is important to understand the challenges presented by it and the steps to address these challenges. The priorities here are transparency, fairness, and security. At the moment, researchers are working to reduce gas fees associated with MEV, optimize MEV extraction, and ensure an equitable MEV environment for all market participants. 

Traders exchanging one token for another using the graphical user interface of decentralized applications are often unaware of MEV activities and their impact on transactions. MEV can also impact price and market dynamics. Such a lack of transparency can hinder the growth and adoption of DeFi.

At the protocol level, Ethereum developers are working on proposals like Mekka to minimize the impact of MEV. There are also project-specific developments like MEV-Aware front-ends and optimal transaction ordering aimed at minimizing MEV. Research organizations like Flashbots 2.0 are building solutions to minimize the negative externalities of MEV and with continued efforts, MEV in DeFi could end up being a thing for the common good instead of one party taking advantage of everyone else without their knowledge.