A&T View: The Current Status, Issues, and Improvements of Ethereum MEV Extraction Mechanism

Author: Liam, A&T Capital

01 Summary

TL; DR

MEV refers to the economic benefits brought to the entity that designs a specific order of executing N transactions. Whenever transaction ordering is involved, the generation of MEV is almost inevitable. It is crucial to regulate MEV extraction to maintain the decentralization and censorship resistance of blockchain networks.

After the Ethereum merge, the extraction and distribution of MEV are dominated by the MEV-Boost system proposed by Flashbots. MEV profits flow to four types of entities: MEV Searchers, Block Builders, Block Proposers (Validators), and the Ethereum network itself.

From the consequences that MEV brings to the entire system, it can be categorized into beneficial, neutral, and harmful types. The core issues that projects in the MEV space need to address are how to avoid harmful MEV extraction and how to distribute beneficial and neutral MEV profits.

Existing private RPC solutions are based on trust assumptions, where users' transactions may still be leaked, front-run, or even censored. Additionally, the monopolistic position of some block builders over private order flows makes MEV extraction more opaque and centralized.

In the MEV-Boost system's profit distribution scheme, users' interests are not considered. As creators of MEV extraction opportunities, it is only basic to ensure that their reasonable interests are not infringed upon. It should not only guarantee that their transactions are not front-run but also return a portion of the MEV profits to them.

To solve the "front-running" problem, cryptographic technology should be utilized. Based on "encrypt-sort-decrypt-execute," users' transactions can be encrypted locally, achieving consensus on the order without anyone reading the transaction content, then decrypting the content, and finally executing the transactions according to the agreed order.

In addition to distributing MEV profits to "searchers who discover MEV opportunities," "builders who construct the highest value blocks," and "proposers who have the right to produce new blocks," a portion should also be allocated to "ordinary users who create MEV opportunities."

02 Main Text

1. Who are the stakeholders in MEV?

• What is MEV? The meaning of MEV varies in different contexts. To avoid confusion, this article adopts a relatively narrow but precise definition:
  MEV (Maximal Extractable Value) refers to the economic benefits brought to the entity that designs a specific order of executing N transactions.
  Who are the stakeholders in MEV? After the Ethereum merge, the extraction and distribution of MEV are dominated by the MEV-Boost system proposed by Flashbots. According to statistics from mevboost.pics, about 90% of blocks have been produced by the MEV-Boost system since November 2022.
  

(Figure 1: Slot Share statistics from mevboost.pics)

In the current system, the stakeholders of MEV on the Ethereum mainnet include users, wallets and RPCs, MEV Searchers, Block Builders, and Block Proposers (Validators). The MEV value chain can be broken down into four parts: origin and upstream, midstream, and downstream.

(Figure 2: The MEV value chain)

Origin: Creating MEV opportunities, providing editable space for MEV extraction

Users: General users of the blockchain who initiate transactions for non-MEV extraction purposes. This can include end users, project parties, oracles, and exchanges, etc. These transactions can be seen as the "raw materials" for MEV extraction.

Upstream: Completing signatures and then broadcasting transactions from local to the network

RPC Providers: Able to read the content of user transactions first and decide where the user's transactions are sent
Wallets: Determine the user's default RPC

Midstream: Auctioning MEV opportunities in public or private environments and determining the distribution of MEV profits

Mempool: A publicly transparent transaction pool within the Ethereum network, visible to anyone, storing transactions waiting to be packaged on-chain.

Private Order Flow: A trusted private transaction pool, open only to specific MEV Searchers or Block Builders, also storing transactions waiting to be packaged on-chain. The creators of private transaction pools can be RPC providers, Block Builders, or third-party projects.

MEV Searchers: Continuously listen for user transactions that have been broadcast but not yet packaged, searching for MEV opportunities, and packaging user transactions and transactions that can extract MEV into a bundle, which is then sent to Block Builders.

Block Builders: Select a series of transactions from the transactions they can receive to package into a new block and send it to relays. Transaction sources include Mempool, Bundles submitted by MEV Searchers, and private order flows.

Relay: Selects the block with the highest fees from the blocks they can receive and sends it to Block Proposers.

Downstream: Proposes new blocks, allowing users' transactions and MEV-extracting transactions to achieve network consensus, gaining finality, and realizing MEV profit distribution.

Block Proposers: Select the most advantageous block from the blocks they can receive and propose it on-chain. The most advantageous block generally reflects the ability to collect the highest fees, although in practice, some blocks with relatively low fees are proposed for other purposes. Block Proposers are also Validators, selected based on the blockchain consensus mechanism.

2. How is MEV distributed?

Under the MEV-Boost system, MEV flows to four types of entities: MEV Searchers, Block Builders, Block Proposers, and the Ethereum network itself.

MEV is directly captured by MEV Searchers and flows to Block Builders, Block Proposers, and the Ethereum network itself in the form of Gas Fees.

The execution of transactions that extract MEV brings income to the MEV Searchers who created these transactions, with the cost of this income being the Gas Fees paid by the MEV Searchers; part of the Gas Fees is burned according to the EIP-1559 protocol, and another part flows to Block Builders in the form of Tips; Block Builders transfer most of the Tips directly to Block Proposers as MEV Rewards (in most cases, Block Builders retain a portion of the Tips, but there are also situations where they provide additional subsidies to Block Proposers).

(Figure 3: Illustration of MEV distribution)

MEV = Profits generated from executing transactions in a specific order
MEV = MEV Searcher profits + Block Builder profits + Block Proposer profits + value captured by the Ethereum network
MEV = (Bundle income - Gas costs) + (Tips - fees paid to Block Proposers) + (fees paid to Block Proposers) + (ETH burned according to EIP-1559)

For MEV Searchers, MEV profits reflect the "income generated from the execution of transaction bundles submitted by MEV Searchers minus the Gas costs of the bundles."
For Block Builders, MEV profits reflect the "execution layer income from the blocks submitted by Block Builders minus the fees paid to Block Proposers."
For Block Proposers, MEV profits reflect the "fees paid by Block Builders."
For the Ethereum network, MEV profits reflect the "ETH burned according to EIP-1559."

3. Types of MEV

From the perspective of MEV strategy types, it can be divided into "back-running" strategies and "front-running" strategies;

From the consequences that MEV brings to the entire system, it can be categorized into beneficial, neutral, and harmful types:

In practice, strategies for extracting MEV profits are numerous, and we will only provide one of the most common examples for different types of MEV.

Liquidation transactions in lending protocols:

This is a transaction that extracts MEV based on a "back-running" strategy. The "back-running" strategy requires closely following a specific transaction to be effective. For example, in over-collateralized lending protocols, when the price feed from oracles changes and causes a borrower's account to reach a liquidatable state, initiating a liquidation immediately after the price change is profitable.

Timely liquidation can reduce the probability of bad debts occurring and help maintain the stability of the entire lending protocol, so this type of MEV-extracting transaction is considered beneficial. Although the essence of the profit comes from the borrower's loss, it also serves as a penalty for the borrower's failure to repay the debt in time, and the borrower has also acknowledged this potential risk when borrowing funds.

Arbitrage transactions across DEXs:

This is also a transaction that extracts MEV based on a "back-running" strategy. After a user completes a transaction on a DEX, due to slippage, there may be price differences for the same token across different DEXs. MEV Searchers can profit by executing an arbitrage transaction, buying on the DEX with the lower price and selling on the DEX with the higher price.

Sandwich attacks:

This is a transaction that extracts MEV based on a "front-running" strategy. When MEV Searchers listen to a user's transaction on a DEX that has not yet been packaged and confirmed, they insert a transaction before the user's transaction, causing the user's slippage to increase and execution price to worsen, and then insert another transaction in the opposite direction after the user's transaction, profiting from the user's additional slippage loss.

Although sandwich attacks are also arbitrage transactions, their profit comes from the losses of ordinary users, and they profit at the expense of other users, which is considered harmful.

Most MEV generated from "back-running" strategies is considered beneficial or neutral because these transactions do not affect any transactions that precede them, do not harm the reasonable interests of other users, and some strategies are also beneficial to the stability of the DeFi system; while most MEV generated from "front-running" strategies is considered harmful because the profits from these transactions are often based on putting other users at a disadvantage.

4. What problems do projects in the MEV space solve? What issues remain?

Whenever transaction ordering is involved, there will be opportunities for MEV extraction, which is almost unavoidable. In this context, projects in the MEV space are dedicated to solving two problems:

1. How to prevent harmful MEV?
2. How to fairly distribute beneficial and neutral MEV?

The current solutions are as follows:

Regarding the "prevention" issue:

Projects provide users with private RPCs and promise that transactions broadcast through these RPCs will not be front-run. For example, Flashbots Protect and OpenMEV, which serves Sushi Guard.

In practice, private RPCs aggregate users' transactions into "private order flows" and broadcast them to specific MEV Searchers and Block Builders, with the condition of enjoying "private order flows" being compliance with abandoning MEV extraction methods based on "front-running," or else they will be kicked off the whitelist.

(Figure 4: Current solutions for MEV)

Regarding the "distribution" issue:

MEV-Boost creates an off-chain MEV opportunity auction market, where MEV Searchers, Block Builders, and Block Proposers each play their roles and share MEV profits.
MEV Searchers compete in hardware and algorithms to find MEV extraction opportunities within a limited time and need to give up enough profits (pay the highest Gas Fees);
Block Builders compete for order flow resources, ensuring that the blocks they build can include higher execution layer rewards, making them more likely to be accepted by Block Proposers;
Block Proposers have the right to propose new blocks and can decide which transactions are packaged on-chain, but they may not necessarily have the same MEV extraction capabilities as MEV Searchers or the rich order flow resources like Block Builders. Instead of building blocks solely through the Mempool, they might as well connect to MEV-Boost, "following" the plans of Block Builders to gain higher execution layer rewards.

The remaining issues are:

The private RPC solutions are based on trust assumptions, where users' transactions may still be leaked, front-run, or even censored.
Private RPCs bring private order flows, and the monopolistic position of some Block Builders over private order flows can make MEV extraction more opaque and centralized.
In the distribution scheme of MEV-Boost, users' interests are not fully addressed, and users do not benefit from MEV extraction.

5. What are the directions for improvement?

To solve the "front-running" problem, cryptographic technology should be utilized. Based on "encrypt-sort-decrypt-execute," users' transactions can be encrypted locally, achieving consensus on the order without anyone reading the transaction content, then decrypting the content, and finally executing the transactions according to the agreed order. This solution eliminates the trust assumption and no longer requires private order flows.

To achieve a fairer distribution, the MEV profits that users deserve should be returned. As creators of MEV extraction opportunities, it is only basic to ensure that their reasonable interests are not infringed upon. It should not only guarantee that their transactions are not front-run but also return a portion of the MEV profits.