I have written about Ethereum’s expensive gas fees earlier. The fees are an important source of revenue for miners in a volatile crypto market where double-digit price swings are not uncommon. But they are not the only source of profits. The Bank of International Settlements (BIS) released a bulletin last month highlighting the need to design regulations pertaining to Miner Extractable Value (MEV) – another profit spigot for miners.
MEV is an umbrella term for an assortment of trading strategies and techniques that they are used by miners to maximize profits. Some of these strategies are considered illegal in mainstream markets. In the mostly unregulated world of cryptocurrencies, however, they have become a vital source of revenue for crypto miners.
What is Miner Extractable Value (MEV)?
Typically, miners in a blockchain are expected to choose and order transactions based on fee and tip amounts. But that is not what always happens. Miners change the order of transactions in a block to maximize their profit potential.
In practical terms, this means that they can place transactions in front of significant client orders that might move markets. For example, even if a sell transaction to sell 100,000 tokens has a lower tip amount as compared to one for purchasing 10 tokens, the miner might choose the former transaction and place its own order in front of it. Or they might place short-term transactions at the back of client trades i.e., put their transaction immediately behind a client order to coattail on its effect in the markets. Sometimes they conduct sandwich trades i.e., they insert trades in front of and behind client trades. The importance of MEVs to miners is such that there hire the services of MEV Searcher bots which specialize in implementing profit-maximization strategies.
While MEV strategies are profitable for miners, their overall effect skews the transaction’s effect on trading markets. It also causes congestion in the network, inflating transaction fees and confirmation times.
MEV profits are proportional to a chain’s complexity. With its smart contracts that execute decentralized finance (DeFi) transactions, Ethereum is currently one of the more complex public blockchains. According to figures quoted in the bulletin, miners have made profits of between $550 million to $650 million on its network since 2020. “Not only does this profit come at the expense of other market participants, but the miner’s transactions also delay other, legitimate transactions. It thus forms an ‘invisible tax’ on other market participants,” the bulletin stated.
Within the crypto industry, MEV is well-known and is used often by arbitrageurs and high-frequency traders. It also has benefits. According to some accounts, MEVs are useful in liquidating bad loans and correcting price distortions for the same token from different exchanges.
While MEV resembles trading that is deemed illegal in traditional finance, the unregulated ecosystem of cryptocurrency and DeFi markets has helped it thrive and become standard practice amongst miners.
Regulating MEV is not an easy task. A proper understanding of the process, and clear delineations of roles played by each actor in it, is needed before. For example, it is not clear whether miners can select or are responsible for selecting transactions to include in a block. Memory pools, from where transactions are selected, are public sites. That said, MEV Searchers are not said to have the same visibility into memory pools as miners.
Another point to consider: the decentralized blockchain argument. It can be difficult to bring a case for regulation against an ecosystem that is decentralized and does not have single point of contact. But that assertion by blockchain enthusiasts should be taken with enormous grains of salt. Despite claims, most major cryptocurrencies are not decentralized. Mining pools with budgets and valuations that run into millions of dollars dominate the mining ecosystem for most blockchains. MEV profits act as further incentives in proof-of-work (PoW) mining cryptocurrencies for big miners to expand their operations by accumulating firepower that enables them to mine more coins.
The BIS bulletin’s authors also raise a point about the legal implications of transacting on a protocol. “In contrast to traditional markets, anyone who participates in such an ecosystem essentially accepts the rules encoded in its protocol. It is therefore unclear whether a participant could object if someone exploits those rules to their advantage,” the authors write. A self-regulatory organization (SRO) might be a possible answer but there are no cryptocurrency-led initiatives or SROs to enforce a prescribed code of conduct for participants in the network.
Finally, it is also difficult to regulate entities that are in a state of transition. Ethereum, the biggest source of MEV profits, is expected to change to proof-of-stake (PoS) mining from PoW later this year. After The Merge, as the event is being called, there will be no mining of eth- Ethereum’s native token. Instead, validators will propose blocks for inclusion in its blockchain and Block builders will become responsible for assembling and ordering blocks.
But the separation of duties is not clear. Assuming that these are two separate systems, what’s to stop them from colluding with each other for profits?
There’s also the question of Uncle blocks. Unlike Bitcoin, which orphans blocks that are produced right after the main block is produced, Ethereum uses the concept of Uncle blocks that share revenues with the miner that assembles a block in a PoW system. Implementing MEV strategies on Uncle blocks could multiply those revenues.