Miners are some of the most crucial crypto network players. In a network like Bitcoin and Ethereum that utilises proof-of-work (PoW) and Proof-of-Stake (PoS) consensus mechanisms, miners are responsible for validating transactions and securing the network.
The miners select and aggregate network transactions into blocks. They are the ones responsible for choosing the transactions that come from the network memory pool into the mined blocks. For every successful transaction verified, the miners get rewarded a transaction fee.
Given most miners depend on network activities as a source of income, they tend to prioritise transactions that pay more. The mining process does not come with the protocol picking the approved transactions. Instead, the miners can view the ones that pay the best and prioritise them. The more the transaction pays in fees, the higher the miner profits. Miners can reorder, cancel, or insert transactions within the blocks they produce. This can allow for tactics such as “front-running”. This blockchain-generated profit is known as “miner extractable value” (MEV).
There are various ways through which the MEV can happen on a network. These include;
Exchange arbitrage and gas price bidding wars
The main form of MEV currently comes from the increased third-party bots looking to make profits from arbitrage trading on decentralised exchanges (DEXs). Arbitrage crypto trading works when two various crypto exchanges offer the same tokens at different prices. The bots can analyse the market to realise these differences and make a profit by buying and selling until the value of the assets on both exchanges reaches the same or similar price.
These price differences however never stay for long. This means the bots must ensure faster transactions if they are to earn a profit. With various traders opting to use the trading bots, the gas price bidding comes up as the one who pays the most gas to get their transaction approved first.
While the bidding wars might work for the few traders at the moment, they can have various effects on the network. As the DeFi becomes popular the wars will likely intensify. It means that at one point some traders would not even afford to use the platforms or will have to wait so long before transaction confirmation.
Lending protocol liquidations is another way through which an MEV opportunity occurs. It happens such that the lending protocols like Aave and Maker require banks to deposit some collateral in the form of various assets like ETH before they can borrow assets on the platform.
These platforms allow the trader to borrow only up to a certain level of their collateral. However, when the collateral’s price drops below a certain threshold, part of the collateral is then liquidated and put into an auction. Miners reordering transactions during auctions can lead to substantial increases in miner profit, making them an MEV opportunity.
Front running is when the miner places their own transaction in the block before another transaction to profit from it.
The crypto market works such that the demand and supply affect the value of the tokens. Miners already understand the possible value impacts from various transactions. If they feel an impending transaction would create a value increase, they will ensure their transaction runs ahead of the other bigger transaction that will increase the asset price.
The front running concept comes from traditional finances. Just like the crypto world, various transactions affect the value of stocks. If a stock trader realised an impending transaction would increase the value of a company’s shares, they would typically purchase theirs before the larger transaction.
Given that miners have all transaction details, they can front-run easily, with reports indicating some of them making millions from the technique.
The other way to obtain MEV from transactions is through sandwiching. This is where instead of placing the chosen transaction before the main transaction, the miner finds a way to place it in the middle of the other transactions.
Just like with the front running, the miners have anticipated a value change. An example is if a DEX running on top of Ethereum has a transaction slippage which impacts the value of the tokens. The miner will find a way to place their transaction between the buying and selling transactions. This will inflate the gas fees which means more money earned for miners in the process.
The Underlying problems with MEV
The idea about miner incentives was all about encouraging the nodes to secure the network. The idea of MEV was not part of the plan. However, having come up, it has various constraints to the network. The blockchain networks that run smart contracts like Ethereum are the most susceptible to MEV. However, others without smart contracts like Bitcoin are also not free from it.
The idea behind the differing risks between the various blockchains is the fact that MEV accumulates on a blockchain depending on the complexity of the chain. The proof-of-work protocols tend to destabilise the consensus and can easily get corrupted when left for long. This does not allow the miner enough time to hold the less paying transactions at bay long enough.
For the blockchain that runs based on smart contracts, the underlying provisions by the involved parties make it quite complex. This allows MEV to accumulate long enough until all the provisions are reached. With Defi and NFTs becoming more popular, the Ethereum network will get more complex. This means network users might have to pay even more for faster transactions.
The main concern that comes with the MEV is the increased transaction costs. Most of the network users value fast transactions. They are then forced to pay more to ensure their transactions are validated fast enough.
With more than $730 million collected from MEV in 2021 alone, platforms are becoming costly to use. Some studies have established that when unabated, more than $2 trillion would be collected annually from MEV.
Most people tend to use Defi and other cryptocurrencies for their decentralised nature and ease of transaction, this however might become more difficult with widespread MEV. It means with time, Ethereum might get hindered in the long run.
The other way MEV can be an issue, in the long run, is an eventual fork. As Ethereum becomes more functional with DeFi and NFTs, it attracts more users. This means it will require more payments to get a transaction validated. These fees might even get to higher levels than the block reward. At such a point, a fork of Ethereum might come up to offer transaction validation on a first come first serve basis.
Possible solutions to MEV concerns
As MEV becomes more popular in the Ethereum network, it means with time miners will become more powerful. They will have the authority on transactions that could affect supply and value. Given the decentralised nature of blockchains, that would be running against the ethos of the network. That is why some solutions are already being floated.
Some people might have thought the London upgrade was an ideal solution when it is not. The move to proof-of-stake (PoS) on ETH 2.0 also looked like a solution. Still, there are miners in the new protocol, except in this case they stake held tokens. At the same time, the complexity that comes with running smart contracts remains and gets more severe as the Ethereum network becomes more user friendly. It is more likely that there cannot be possible MEV mitigation without a change of the underlying architecture.
The first option to solve the MEV concern is to create an off-chain market. Given MEV is something that automatically comes with the blockchain, it is challenging to eliminate within a network. For example, some network users can suggest a flat-rate transaction fee, such that all transactions seem equal. Still, the miners can reach out to the traders and those willing to pay more would still be prioritised. This will end up in a similar situation as the current MEV challenge.
The other viable MEV solution is to look for an alternative protocol. Already, the Onomy protocol is positioning itself as an option. It aims to have a leaderless system for ordering and throughput in transactions. This ensures all nodes operate on the same wavelength without the leading ones choosing the most profitable transactions.
Changing the underlying architecture of a blockchain network can destabilise the network which might negatively impact the whole crypto market.
The idea behind transaction fees was to motivate the miners to validate transactions and secure the blockchain networks. However, as these networks become more integral, the need for more speed has led to MEV concerns. At the moment the possible solutions can destabilise the protocols hence why traders must be prepared to keep paying more, unless another protocol comes along or the network makes it unprofitable to charge higher fees.