Original Title: 《MEV and Flashbots: The Uniquely DeFi Tale》

Author: 0xFishylosopher

Compiled by: 深潮 TechFlow

Introduction

MEV, or Maximum Extractable Value, is a byproduct of blockchain design and a unique DeFi phenomenon.

Essentially, MEV is just an instance of profit maximization behavior, where validators operating on the blockchain seek to maximize their profits from validating transaction tasks. While some may argue that MEV can be beneficial by increasing capital efficiency, it significantly impacts the user experience of decentralized applications, including higher gas fees, slippage, and risks such as validator collusion and centralization.

In this article, 0xFishylosopher will first explore MEV as a theoretical concept and the systemic risks it poses to the ecosystem. Following that, using Flashbots as a case study, the article will discuss how the DeFi community attempts to address all these negative externalities of MEV.

"Flash Boys" Club

MEV is a feature of blockchain technology, not a bug. In a given blockchain network, validators (or miners in a traditional PoW model) decide which data to include on-chain. Specifically, they can control the order of data on the chain. It turns out that certain transactions provide validators with significant profits. Therefore, as rational economic agents, validators will arrange transactions in a way that maximizes transaction fees.

The concept of MEV was first detailed by smart contract researcher Phil Dainan in a significant paper titled "Flash Boys 2.0," where the researcher emphasized the existence of numerous bots and arbitrage agents trying to "predict and exploit" regular users' DEX trades, similar to how high-frequency traders in traditional finance actively optimize trade latency. To understand the scale of this phenomenon, in just the last 24 hours of writing this article, MEV operations have generated a profit of 2,578 ETH, approximately $4.9 million at current prices.

Although MEV is a generic term encompassing many different arbitrage methods and scenarios, several key features underpin many MEV opportunities in DeFi. First, much of the MEV is realized through a process called "Priority Gas Auctions" (PGA), where users can pay higher transaction (gas) fees to have their transactions executed first. Since many arbitrage bots rely on having their transactions executed first to profit, these bots participate in gas bidding wars, continuously raising prices to have their transactions run by validators, leading to severe network congestion that prevents regular users from executing their transactions unless they also pay exorbitant fees.

On the other hand, validators are one of the main beneficiaries of this situation. In fact, the greater the power, the greater the profit: because validators (at least theoretically) have the power to decide which transactions to run, they can earn "ordering optimization" fees by determining which transactions yield them the most cash. However, in practice, having validators complete the entire MEV search, packaging, and execution process is too cumbersome. Therefore, most of the "ordering optimization" is outsourced to specialized searchers, builders, and relayers, who can be imagined as "secretaries" for validators, simplifying the MEV process in exchange for a share of the profits. Specifically, searchers look for MEV opportunities, builders bundle these opportunities into complete "blocks," and relayers send these complete "blocks" to validators or actual block builders. Thus, the overall situation of the modern MEV ecosystem is as follows:

As previously mentioned, while the arbitrage enabled by MEV can bring some benefits, including higher capital efficiency and ensuring price consistency across different exchanges, there can be significant negative externalities for end users, such as higher transaction costs, slower execution speeds, and increased slippage (e.g., sandwich attacks). However, this is not the greatest risk that MEV poses to blockchain—especially if validators collude, MEV can actually undermine the security guarantees of the blockchain consensus layer.

This security issue stems from the problem of incentive misalignment—among all these profitable MEV opportunities, miners can earn more profit by optimizing transaction fees rather than adhering to a constant block reward allowance. As Dainan wrote:

Thus, miners can fork a high-fee block, keeping some fees to attract other miners to build on that fork. In extreme cases, the misaligned incentives can lead to economically rational miners' strategies becoming chaotic, thereby reducing the security provided by block confirmations.

This is known as an "undercutting attack," one of several ways MEV can undermine the fundamental security guarantees of blockchain. Other known attacks include "time bandit attacks," where validators do not collude to steal profitable transactions from the current block but instead collude to rewrite MEV opportunities in past history. Furthermore, MEV extraction does not even need to occur on-chain, as it can be completed through off-chain backdoor transactions, such as trades between large traders and validators.

Thus, we can see that MEV practices face significant risks within the blockchain ecosystem.

Flashbots and the War Against MEV

Given the potential severe consequences of unrestricted MEV, several projects and teams have been dedicated to mitigating the negative externalities of this practice. One of the most important teams in this field is Flashbots, a project committed to realigning MEV incentives in a way that sufficiently rewards validators for honestly building the chain while alleviating the worst impacts on regular users.

To this end, Flashbots attempts to take three different steps: (1) revealing the "dark forest" of MEV, (2) democratizing MEV extraction, and (3) redistributing benefits back to the ecosystem. To achieve the first goal, Flashbots has a dedicated product called MEV-inspect, aimed at "illuminating" the "dark forest" of MEV to quantify the negative externalities caused by MEV and highlight the scale of the problem.

On the other hand, the two goals of democratizing MEV extraction and redistributing benefits are more complex, involving a whole suite of products that have gradually evolved as the scope and focus of the issues have changed. In some ways, it can be said that Flashbots' product development history over the past two years itself serves as a timeline for the growth and development of Ethereum.

The first significant product released by Flashbots is the MEV-Geth client, a modified version of Ethereum's Golang that better prevents MEV manipulation by routing transactions to private transaction pools. An MEV auction market was built on top of this new client, using a "first-price sealed-bid" method (also known as "blind bidding"), where each participant is allowed to submit only one price, and auction participants do not know the prices bid by others. Through this design, Flashbots alleviated the previously discussed "price bidding" wars.

The guiding principle behind creating MEV-Geth and the MEV market is to decentralize the power and responsibility of validators in building blocks through an incentive realignment process known as "proposer-builder separation." Validators using MEV auctions do not have to engage in the complex MEV search and transaction packaging process but can simply look at the MEV market to find which transactions will provide them with the highest MEV and place a single bid reflecting their actual preferences. Additionally, to prevent validators from including their own transactions and profiting from front-running user transactions, the actual transaction details (buys, sells, liquidations, etc.) are only made public after the block is built.

So, why would validators use this algorithm and forgo the previously mentioned profitable MEV opportunities? This is because the Flashbots algorithm only requires validators to select MEV transactions from the market, making it easier and cheaper for them. As more high-quality MEV transactions flow through this market rather than directly on-chain, validators can achieve higher returns by sticking with Flashbots. The results have been impressive: shortly after the release of MEV-Geth, over 90% of Ethereum validators began using this solution, demonstrating the importance and effectiveness of incentive realignment in addressing potential issues. However, as the Ethereum ecosystem evolved, transitioning from a proof-of-work (PoW) model to a proof-of-stake (PoS) model starting in September 2022, the changes to this "proposer-builder separation" concept also became inevitable.

The primary reason PoS is more efficient than PoW is that, in PoW, each node must build and propose blocks from scratch, while in PoS, only a few validators act as primary block proposers to append data to the blockchain. While this is good for environmental and computational efficiency, it may introduce additional centralization risks due to the attractive nature of MEV, especially if validators ("proposers") collude with key "builders" in the market. Even Flashbots' own private transaction pool may be tempted by collusion, and of course, placing trust in a single entity (like Flashbots) contradicts the principles of decentralization.

The release of MEV-boost has decentralized the "supply side" of this MEV market. MEV-boost not only includes transactions from Flashbots' private transaction pool (essentially a monopoly) but also allows any builder running this software to submit transactions to all participating validators. For validators, as more builders participate in constructing all these different blocks, it allows them to earn more income and balances which validators can access which transactions, thereby establishing a more robust and secure ecosystem. Like MEV-Geth, this novel design realigns the incentives of multiple parties to avoid centralization risks and has achieved tremendous success, with over 85% of the network adopting this design, where Flashbots only relayed 34% of the transactions.

Flashbots SUAVE

Thus, so far, the task of mitigating all centralization risks and protecting decentralized finance from the most harmful effects of MEV remains uncompleted. By implementing proposer-builder separation, Flashbots' solution has decentralized or redirected the key powers and responsibilities of validators to "builders," introducing these "builders" as distinct entities from those selecting transactions for validators. However, there are significant economies of scale in the builder role, which in turn can lead to centralization risks in the builder role.

So, what do the economies of scale in the builder role look like? Recall that the previously mentioned searchers, builders, and relayers play different roles: searchers look for MEV opportunities, then send them to builders, who in turn send complete blocks to relayers. This means that searchers must choose who to send the results to. To maximize their returns, they will choose the highest-quality builders, whose transactions are most frequently selected by validators. As more high-quality transactions flow to top builders, this creates a centralization effect, where top builders will always receive the highest quality MEV transactions from searchers, thereby consolidating their position.

It has been proven that this builder centralization effect exists. In the last 24 hours of writing this article, the top 5 builders submitted approximately 90% of the total MEV-Boost blocks. As this degree of centralization increases, these oligarchs may begin to leverage their dominance to manipulate transactions, including colluding and censoring certain transactions, which could again jeopardize the security of the underlying blockchain. This is the motivation behind Flashbots' latest project: a unified auction for value expression, which aims to disband the block building process from any single blockchain and outsource it to a separate network, thereby decentralizing the role of block builders.

SUAVE is essentially an independent, dedicated block sorting chain responsible for the transaction memory pool and the builder role, while the validators of the native chain (like Ethereum) will be responsible for the proposing and proving roles. As we can see, SUAVE is a natural extension of the "proposer-builder separation" principle, where we place proposers and builders on two completely independent chains so that both are sufficiently decentralized and separated from each other. Additionally, the vision for SUAVE is that it will serve as a universal sorting layer for many different chains, allowing validators from Ethereum, Arbitrum, Polygon, or any other EVM chain to use SUAVE to find the best MEV opportunities, not only for their native chain but also for cross-chain MEV from cross-domain transactions that cannot be accessed merely by looking at that chain's transaction memory pool.

Despite SUAVE's grand vision of ultimately benefiting all parties and making the Ethereum ecosystem more decentralized, several key design issues remain to be addressed in the six months since its establishment in November 2022. For instance, one core question is whether to build SUAVE as a separate L1 chain (similar to Chainlink), use a Rollup solution, or "borrow" the restaking services of Ethereum validators, such as Eigenlayer. Each solution has its unique trade-offs in terms of implementation convenience, validator retention, security, and flexibility, which we will not discuss in detail here.

Another core issue is whether SUAVE will release its own token. Although the SUAVE forum currently denies that it will "temporarily" not launch its own token and continues to use ETH as its native token on its chain, there are several questions about whether Flashbots will adhere to this, especially since launching a SUAVE token seems to be the most economically viable option for Flashbots as a private company in the long run. Additionally, it can be fairly argued that the reason Flashbots believes it can raise a $1 billion unicorn valuation in a bear market is the implicit commitment to launching a SUAVE token in the future.

So, what is preventing Flashbots from announcing that it is launching a SUAVE token? It turns out that launching a token brings several headache-inducing design decisions. For example, is this token useful for certain transactions, or is it merely "another governance-only token"? If this token is to have utility, what would that utility look like? How to incentivize different stakeholders of Flashbots (e.g., different chains, end users, builders on Flashbots, etc.) to use and trust this new token instead of more mature tokens like ETH or even L2 tokens like ARB? In any case, complex incentive alignment processes need to be addressed, so the Flashbots team has every reason to temporarily avoid this issue.

Beyond Flashbots: The Big Picture for the Future of DeFi

While it is still too early to determine what form SUAVE will ultimately take and whether this brand-new sorting chain can achieve its initial goals and adjust incentives in a way that truly mitigates the negative externalities of MEV, I believe that MEV and Flashbots represent a typical image of the various trade-offs, issues, and principles involved in designing a truly decentralized financial system.

First, as previously mentioned, MEV is a feature of blockchain technology, not a bug. These arbitrage opportunities and profit incentives for validators stem from the immediate accessibility of the blockchain and guarantee the capital efficiency of DeFi. The negative impacts of MEV, including network congestion, gas wars, and slippage for end users, are merely byproducts and negative externalities of this process.

By definition, negative externalities do not affect the agents engaging in negative behavior. In this case, the network congestion and slippage affecting end users do not harm the validators or arbitrage bots engaging in this profitable behavior. In traditional economics, purely market-based systems do not handle all these externalities well. Traditionally, governments or other regulatory bodies intervene to correct market dynamics and minimize the impact of negative externalities (e.g., taxing tobacco and alcohol).

On the other hand, DeFi is inherently trustless and opposes any form of human government enforcement. Its closest "enforcement agency" is achieved through encoding rules and regulations in code (e.g., through smart contracts) to provide certainty and transparency. Therefore, as the story of Flashbots illustrates, reducing the negative externalities of MEV always relies on a complex process of incentive redesign and alignment. After all, like Wall Street quantitative traders, DeFi arbitrage bots are not known for high moral standards and good intentions.

Using incentive redesign to reduce the negative externalities of MEV is not just an intrinsic feature of the Flashbots team. Besides Flashbots, many other teams are attempting to realign incentives and develop protocols to mitigate the impact of MEV. For example, Chainlink's Fair Sequencing Service (FSS) utilizes its decentralized oracle network to outsource the "transaction ordering" process to validators, achieving goals similar to those pursued by the SUAVE network. Another example is the "CoW" mechanism on the CoW protocol (formerly Gnosis Chain), which automatically binds trades together based on whether they are complementary (e.g., I want 1 ETH for 1500 USDC, while you want 1500 USDC for 1 ETH) and uses solver algorithms to ensure everyone trades at optimal prices.

However, redesigning incentives in a trustless decentralized setting can be a very challenging task, as fundamentally, you are trying to offset economies of scale. For instance, in the case of builder centralization in Flashbots, builders that have already "proven their worth" are more likely to be "trusted" by searchers, who will give them more high-quality trades, consolidating their position as market leaders. Identifying, addressing, and implementing decentralized alternatives through incentive realignment is essentially a game of "whack-a-mole"—you never know what centralization vulnerabilities and hidden economies of scale the newly introduced incentive systems may contain, all of which will only make sense in hindsight.

Moreover, in a complex system with many different stakeholders and agents (such as a blockchain), it is nearly impossible to avoid externalities, as there will almost certainly be a corner where the actions of one stakeholder will spill over and affect the actions of another stakeholder. As Dainan demonstrated in "Flash Boys v2.0," many of these externalities can pose real threats that undermine the stability of the entire system. Therefore, any decentralized system—even those with well-designed game theory—will always have this inherent complexity, subtlety, and fragility, where an unexpected vulnerability could threaten its existence.

Compared to centralized systems, decentralized systems do not contain any obvious "single points of failure"—but it is precisely this that makes decentralized systems sometimes more lethal than their centralized counterparts. If there is a flaw in the system design, every node has the potential to become a "single point of failure."

Finally, the story of MEV and Flashbots tells us that maintaining the health of decentralized systems always requires continuous, arduous effort—ongoing participation in the "whack-a-mole" game. The diffusion of trust in decentralized systems requires a diffusion of responsibility and vigilance, especially since there are so many economic incentives at stake: whether good or bad, MEV is always present.