What is Ethereum MEV? Understanding the ‘Invisible Tax’ on ETH Transactions

What is MEV Ethereum?

The MEV, or Maximal Extractable Value, refers to extra profit that can be generated by including, excluding, and changing the order of transactions in a block. It’s extracted in addition to the standard gas fees and block rewards. 

The MEV extraction process leverages the way decentralised blockchains such as Ethereum work. The blockchain favours the most economical and optimised pathway, unlike the traditional financial systems, which work based on a fixed time frame or a first-come first first-served basis. For instance, when buy or sell orders are placed in the network, they are broadcast to all peer nodes before validations. The priority of validations doesn’t depend on the chronological order of placement, but on the economy of it. Originally meant to incentivise the optimisation, MEV over the years have evolved into a threat catching even the attention of regulatory authorities.

How Does MEV Work?

Today, blockchain validations are made efficient by bots, namely ‘builders’ and ‘searchers’. The builders are entities that assemble the transaction orders on a priority basis, while the latter scans and identifies the most profitable transactions. Such bots are crucial for MEV as they play a significant role in deciding which transactions are validated first. 

For instance, when a transaction order is placed, it is broadcast to all nodes for verification. These nodes place the transaction in a mempool, a waiting area where all unconfirmed transactions are put together. The bots can thus scan, detect, and prioritise the most profitable transactions from the meme pool and extract MEV. 

Is Mev Good or Bad? 

Initially, the MEV is considered a reward for optimisation in a decentralised network, thus encouraging wider participation and strengthening decentralisation. In fact, it was originally called “miner extractable value” in the earlier proof-of-work consensus mechanism as an incentive for the miner.  

But as the consensus evolved from proof-of-work to proof-of-stake, the more sophisticated bots emerged. The entry of more powerful bots poses a threat to the very decentralised ethos represented by blockchain. The market participants who possess such sophisticated bots could benefit from MEV, effectively creating an invisible tax on the other users. 

Nevertheless, some of the good uses of MEV include arbitrage to align prices across exchanges and carrying out liquidations to maintain the smooth functioning of the protocols. 

On the other hand, bad MEV strategies such as Front-running, Sandwiching, and Back-running pose a threat to market integrity. Here is a detailed look at some of these practices.

Front-running

In the Front-running strategy, when the MEV searcher/bot detects a buy or sell order placed by a user, it jumps ahead and places a similar order. For example, if the bot identifies a pending buy transaction in the meempool, it places a buying order with a higher gas fee. This will push the price up for the original user, as their transaction will be processed only after completing the buy order placed by the bot. This drives the cost up for the user, and the bot benefits from the price change.

Sandwiching

In the Sandwiching strategy, when the bot identifies a trade order, it places two orders and profits from the price changes. To sum it up, the bot detects a buy order of a user and buys just before the aforesaid order is processed, and sells right after it is confirmed to gain from the price change. 

For example, if Harry places a buy order, a bot detects it. The bot then places two orders, one with a higher gas fee than that of Harry’s and another with a comparatively lower gas fee. When the validator creates the next block, the bot’s order with a higher gas fee is processed first. This drives the price a little, but then comes Harry’s big buy, driving prices considerably higher. The bot’s sell order is processed next, and hence it gains from the increased price. 

Arbitrage

Though arguably regarded as a good use of MEV, it still gives an advantage to the bots. In this strategy, the bot simply buys and sells the same asset but on different crypto exchanges. For instance, when the bot detects a buy order that can significantly push the price higher in a particular exchange but not in another, it places two orders simultaneously and takes advantage of the price changes. 

MEV Protection: How to Protect Yourself?

Since MEV became a contentious issue, the wallets and exchanges started building guardrails against its misuse. Here is a brief look at some of these strategies. 

• Using private relays or private transaction pools: Instead of broadcasting the transaction order to public meempools, they can be routed through private relays. This way, the transaction can remain hidden from bots until it’s added to the block. 
• Setting slippage tolerance: The slippage refers to the anticipated price difference for a transaction. Set a low slippage tolerance limit to avoid manipulations.
• Choose exchanges wisely: Use exchanges and platforms that have built-in MEV protection. 
• Place limit orders: The limit order makes sure that the transaction is carried out at a specific price or better, unlike market orders. This shields users from manipulation.

The Bottom Line

As discussed above, MEV leverages the decentralised and inherent nature of the blockchain network, favouring optimisation. Over the years, it has evolved into a contentious issue raising regulatory and ethical concerns. Its misuse threatens the very fundamental principles, such as decentralisation, that build the digital economy. Meantime, the users are advised to keep themselves informed of its potential risks and opt for proper protection services. 

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