Is MEV a good investment opportunity?

Author: Zixi.eth

1. MEV: Maximal Extractable Value

Introduction MEV originally referred to miners extractable value, applicable under PoW, and measures the profit miners can gain by arbitrarily adding, excluding, or reordering transactions within the blocks they produce. MEV is not limited to miners in PoW blockchains but also applies to validators in Proof of Stake (PoS) networks. Maximal Extractable Value (MEV) refers to the maximum value that validators can extract during block production that exceeds standard block rewards and gas fees by adding, removing, and changing the order of transactions in a block. Currently, MEV generally refers to Maximal Extractable Value.

Now that Ethereum has transitioned to PoS, any user can become a validator by staking 32 ETH. During each block production time, a validator is randomly selected as the block proposer to package and execute transactions into a new state, after which this proposer will package the block for other validators to verify. From the above description, it seems that validators should find ways to arrange the transaction order in the block to be profitable. However, in reality, most MEV is arranged by Searchers. This is because Searchers need specialized algorithmic techniques to perform search calculations and sorting. Searchers submit their algorithms to the proposer through Mempool/private channels, and the proposer subsequently packages them into the blockchain. One manifestation of MEV is the sandwich attack. MEV has both advantages and disadvantages. The advantage is that it can enhance the efficiency of DeFi, as Searchers can quickly arbitrage price differences. The downside is that some MEV severely impacts user experience; for example, attacked users may face higher slippage and a poor user experience, and due to the existence of gas priority fees, Searchers may sometimes significantly increase gas fees, leading to network congestion and a very poor user experience. Figure 1: MEV situation of the top 10 DeFi projects on Ethereum over the years Roles in Ethereum MEV. Searchers are responsible for monitoring public transaction pools and Flashbots private transaction pools, then using algorithms to calculate the most profitable transaction order within blocks, packaging and sending it to Builders. At this point, Searchers will provide a bid, indicating the maximum cost they are willing to pay, which is only visible to the builder and not through the p2p network to everyone, thereby alleviating on-chain usage pressure. Figure 2: Searchers monitor public transaction pools and private transaction pools to use algorithms for bidding

Any user who downloads MEV-Boost can become a Block Builder. Builders accept transactions from Searchers and further select profitable blocks from them, then send the blocks to relays via MEV-Boost. Figure 3: Builders collect bids from different Searchers

Relayers are part of the PBS separation, hosting the blocks sent by Builders for Proposers. Relayers accept blocks transmitted by Builders and pass the most profitable block headers to Validators. Once Validators verify the block headers, the relayer sends the entire block header to the Validators to accelerate their work efficiency. Any user can stake 32 ETH to become a Validator under PoS. Currently, Lido is the largest Validator. Validators can use MEV-Boost to select the most profitable blocks from multiple relayers' proposals and collect priority fees, then choose a Proposer from among many Validators to produce blocks. Figure 5: Proposer (Validator) ultimately selects the most profitable block for construction Forms of MEV: 1. Risk-free arbitrage in Dex.

Searchers analyze on-chain data and use price differences in Dex + flash loans for risk-free arbitrage.

2. Liquidation in lending.

Searchers query on-chain data at the fastest speed to determine which borrowers can be liquidated, then submit liquidation transactions first and collect liquidation fees.

3. Sandwich attack

For example, if I want to spend $1 million to buy ETH on Uni, this will cause a significant price increase for ETH on Uni. Under the condition that the Searcher pays the highest gas priority, the Searcher only needs to monitor the transaction pool, move their purchase of ETH transaction ahead of mine, and then immediately sell after I make my purchase to complete the sandwich attack. Although there is a possibility of failure in MEV, i.e., the gas priority fee is not high enough, the cost of failure is negligible compared to the total cost (failure cost + success cost) as seen in the figure.

Figure 7: In MEV, the cost of failed MEV is very small

2. Does Flashbots Bring an MEV Track?

Flashbots is a research and development company aimed at mitigating the negative externalities caused by MEV (such as on-chain congestion). Flashbots has launched several products, including Flashbots Auction (with the Flashbots Relay), the Flashbots Protect RPC, MEV-Inspect, MEV-Explore, and MEV-Boost.

Here, we will focus on introducing two products: Auction (MEV-GETH) and MEV-Boost. Before the introduction of Flashbots Auction, for example, during the DeFi Summer of 2020-2021, the surge in Ethereum usage brought significant negative externalities, such as high gas fees and Ethereum congestion. This was due to the fact that in the past conventional transaction pools, users broadcast gas bid fees p2p to all nodes, and then miners (now validators) calculated the most profitable blocks. This public bidding method led to high gas fees, and all ordinary retail investors had to bear high gas costs, resulting in a poor user experience.

Moreover, transactions that failed in the auction (i.e., those with insufficient gas bids) would also be restored on-chain, occupying some block space, ultimately leading to wasted block space and reduced miner (validator) earnings, resulting in a lose-lose situation. Therefore, Flashbots established Auction to alleviate the above issues. Auction (MEV-GETH) Auction provides a private transaction pool + a privacy bidding block auction mechanism, allowing validators to outsource the most profitable block construction work without trust. In this private transaction pool, Searchers can communicate privately and do not need to pay fees for failures. MEV-Boost, developed by Flashbots, is an open-source middleware that operates on-chain Validators to complete block building tasks, thereby achieving separation between Proposers and Builders under PoS. PBS has not yet been implemented, which leads to scale effects and centralization, meaning that larger mining farms have more capability to develop algorithms to enhance their search capabilities; however, PBS has already been written into the development history of Ethereum. MEV-Boost MEV-Boost links multiple relays to select the most profitable blocks to hand over to Validators. MEV-Boost currently has over 90% adoption. However, as more users participate in MEV, competition for MEV has begun to intensify. The profits of Searchers have started to decrease, while the profits of Producers have begun to increase. From the currently accumulated data, 64% of the total MEV profits are still occupied by algorithm-driven Searchers. Additionally, MEV also exists on other chains, such as BSC, Avalanche, etc. The competition on other chains is not intense, but the ceiling is relatively low. Figure 8: Searcher gross income is around 64% SUAVE A current trend is the centralization of builders, with CR5 reaching 84.29%. Builders tend to have exclusive order flow (due to privacy features set by this Builder or because this Builder is more likely to choose transactions sent by this user) and can operate cross-chain (users can send transactions from Ethereum as well as from other chains for packaging), leading to increasing centralization of builders. Centralization of builders will undermine the decentralization of Ethereum's PoS. Therefore, to address the above issues, Flashbots developed SUAVE (the Single Unified Auction for Value Expression). Figure 9: Builders are becoming increasingly centralized

SUAVE is an independent blockchain but can be understood as a plugin that can be inserted into any other chain, acting as the Mempool and builder for other chains. SUAVE separates the Mempool and builders of all chains from other roles, achieving specialized management to enhance overall chain efficiency (if multi-chain is not set, then single-chain builders will gradually be eliminated). SUAVE achieves a win-win situation, where the blockchain itself becomes more decentralized, validator income is maximized, searchers/builders can set preferences and potentially increase income, and users can conduct private transactions at the lowest cost. Figure 10: SUAVE architecture Figure 11: SUAVE can achieve cross-chain MEV Figure 12: MEV income split from 2020 to 2022

3. Prospects of the MEV Track

MEV Market and Profit Margin According to statistics from Flashbots, MEV earned a total of 70K ETH, or $133 million, from the top 10 DeFi projects on Ethereum in 2022, a significant decrease compared to the cumulative income of 188K ETH, or $475 million, in the 2021 bull market. The reasons include the transition of on-chain trading to a bear market (the total on-chain Dex trading volume dropped from $1575B in 2021 to $1255B in 2022), and the reduction of on-chain leverage (liquidation of on-chain bankruptcies is also a source of MEV profits, but due to excessive declines, on-chain leverage has decreased); however, the overall gross profit margin increased from 61% in 2021 to 65% in 2022, due to the promotion of Flashbots enhancing the gross profit margin of Searchers. MEV is highly dependent on on-chain activity/trading volume, which is significantly influenced by market conditions; for example, during the 2021 bull market, the overall income ceiling was $476 million. Figure 13: Bull market filled with opportunities, MEV market is large, but gas fees are high and profit margins are low;

Bear market with low trading volume, MEV market is small, but no longer has high gas wars, profit margins are high MEV is a strong cash flow track MEV is a strong cash flow track and is highly positively correlated with cycles (on-chain trading volume, etc.). We compare the data from the 2022 bear market, selecting other DeFi businesses that also have strong cash flows for comparison. Without deducting the costs paid to miners, we find that the total income of all Searchers on the top 10 DeFi projects on Ethereum in 2022 was $133.7 million, which is a significant income in the entire blockchain industry. Although it does not compare to top projects like OpenSea, it is much higher than the income of projects like dYdX, Pancake, Convex, Maker, and Synthetix. Furthermore, this $133 million only includes the top 10 DeFi projects on Ethereum and does not account for income from other DeFi and Layer 2 + other POS Layer 1 on Ethereum. Comparing with other selected competitors, the weighted PS is calculated to be 12.43, and the final weighted PS is used to estimate the reasonable valuation of MEV Searchers, which is approximately $1.662 billion. Therefore, considering the entire Ethereum chain + Layer 2 + other POS Layer 1, the ceiling will be far greater than $1.6 billion. Figure 14: Comparison of MEV income from the top 10 DeFi projects on Ethereum in 2022 with other dapps Figure 15: In 2022, MEV Searcher income ranked second after OpenSea, higher than dYdX, ranking very high among all blockchain projects

Conclusion

In summary, MEV is a rare strong cash flow, highly transaction-related, high-income but relatively low-risk underlying track in blockchain.

MEV strategies may resemble those of quants and market makers, but since they do not bear any counterparty risk, MEV is more robust than quants and market makers (at least it won't be liquidated like some market makers during significant market fluctuations). MEV strategies are more rigid, but the risks are also lower, with the most typical manifestation being arbitrage through sandwich attacks in DEX. From the performance of Searchers in 2022, the MEV income generated by the top 10 dapps on Ethereum was $133.7 million, minus about one-third of miner gas fees, resulting in a net income of approximately $87 million, and with other Layer 1 and Layer 2, the overall MEV income in blockchain is quite high.

Additionally, for other L1s represented by BSC, although the overall scale of BSC's MEV is smaller than that of Ethereum's MEV, due to the lack of a unified bidding system and less intense competition, the overall net profit margin for Searchers will be very high. Furthermore, we have seen MEV projects like Flashbots aiming to create a unified market in Cosmos.

From an investor's perspective, MEV is a typical equity structure project, overall similar to market maker investments, but without counterparty risk, thus overall risk is lower. Since such companies are less likely to issue tokens, the exit paths may only be through mergers, dividends, etc.

The core criteria for evaluating MEV projects are:

1. Whether the search algorithm is reliable

2. Whether it can quote nodes in real-time

3. Control over gas costs

4. Expansion to other chains, etc.

Therefore, the overall technical requirements for the team are relatively high, and it is typically not a BD-oriented industry, which may be more suitable for Chinese individuals.

Thus, when investing in companies similar to MEV, if the valuations in the first and second rounds are low and the team quality is high, it may be worth considering a layout. For some of our portfolios, this could also represent an additional business opportunity.

For example, Blocksec has a significant advantage in front-running when monitoring dark pools and blocking hackers. By simply improving algorithms and leveraging front-running advantages, theoretically, they could enter the MEV track. Similarly, Chainbase is also integrating some trading APIs, and once enough algorithms are abstracted, they could theoretically write their own MEV algorithms based on their nodes to enter the MEV space.