What is MEV?
For starters, maximum extractable value (MEV) involves various techniques used by market actors to gain additional value by exploiting price inefficiencies in blockchain transactions.
One naive form of MEV is called a “transaction sniper.”
Recently, manifestations of this phenomenon have started populating your local Bitcoin meme pools due to ordinal trading. Without going into too much detail, the way cross-chain trading currently works is through the use of Pre-Signed Bitcoin Transactions (PSBTs).
The concept is simple: Some users list photos on the marketplace by drafting a transaction that includes details and the price they want to sell them for. You, a cat lover, can purchase this cat mug by completing the transaction and adding your address, transaction fee and signature. The transaction is then broadcast and eventually settled on the Bitcoin network.
Easy right?
not like that.
Turns out cats are a hot commodity these days and other feline pals who enjoy them are looking forward to your reward. The open nature of the offers allows any of them to interfere with your purchasing process. This is because PSBT listings are auctions, not exclusive sales. Every transaction in the memory pool associated with Cats is up for bidding. The 10-minute Bitcoin block interval opens a window for opportunists to “snipe” each other’s transactions to obtain the most valuable blocks. Nothing is settled until the transaction is converted into a block.
We learn from this that on-chain auctions are vulnerable to the settlement time of the blockchain on which they settle. This creates a particularly thorny problem for anyone with a little more ambition than trading cat pictures.
What causes MEV?
Now what's the big deal with MEV? Surely everyone isn't annoyed by a bunch of deejays outbidding each other for cat pictures?
Answering this question requires opening a whole new can of worms. This will be a bit of a journey into the land of evil coins, but bear with me, I promise it will be worth it.
As you can see, MEV is a big company. To give a rough idea, MEV-Boost, the software responsible for coordinating MEV mining on Ethereum, has distributed nearly two coins in less than two years. 500,000 Ethereum In rewards. That's almost $2 billion!
What drives this entire market, of course, is trading. (Read: Diggins)
On-chain AMMs (automated market makers) use a popular concept called liquidity pools to allow users to trade assets without relying on central order books. Pools typically consist of a pair of assets, such as Ethereum and USDC.
When users want to trade one asset for another, they interact with these liquidity pools. Each trade adjusts the ratio of the two assets in the pool, affecting their relative prices. By removing centralized order books where the buyer needs to match the seller for each trade, AMMs can be deployed as a decentralized on-chain contract.
Once a trading pair is created, any user can trade against the pool or contribute liquidity to it. Contributing liquidity involves providing one or both assets to the pool, ensuring that the appropriate ratio is maintained. Any imbalance creates an opportunity for market makers to engage in arbitrage by buying cheaper assets from the pool and selling them at a higher price elsewhere, such as central exchanges. This activity, along with the fees charged to liquidity providers (LPs) from trading activity, incentivizes people to keep these markets liquid.
If you've heard of DeFi or Uniswap but never looked them up, this is the secret sauce. Liquidity pools can be deployed to trade any asset, and their permissionless nature has made them very popular. Upon closer inspection, we can see that these deals are not fundamentally different from the cat market we discussed earlier – they are just on-chain auctions.
As you might imagine, Ethereum's architecture and additional programmability create a particularly fertile environment for the abuse and manipulation of these auctions.
Perhaps the most popular and intuitive is forward running. Remember that trades on AMMs are not settled immediately. In the same way that catfishers can monitor Bitcoin diaries for exciting trades, Ethereum also has an army of financial mercenaries who diligently monitor every trading opportunity.
Except the ETH kids don't play with that stuff. It's not Private Ryan, it's SEAL Team Six over there. They use several complex techniques to exploit the time gap between when a transaction is broadcast and when it is confirmed on the blockchain. As a result, early runners can place their own trades before the original trade, and profit from price changes caused by their actions. This generally results in average users receiving worse-than-expected prices. One of the worst manifestations of this is the practice of user capping, where a buy order is placed just before a user trades and a sell order is placed immediately after, with the price difference being captured on the original trader's account.
While these dynamics have been controversial because of their impact on user experience, they represent only part of the economics of midsize EVs. the Largest exporter of MEVby a fairly large difference, comes from something commonly known as “Loss vs. rebalancingSimply put, it is a negative form of pooled arbitrage described above that affects liquidity providers.
When the price of assets in the liquidity pool differs from the price at which they were originally deposited, arbitrage traders step in to rebalance the pool to reflect global market prices. This rebalancing process leaves liquidity providers vulnerable, as they are unable to adapt to market fluctuations between blocks. Due to their exposure to historical prices, they become an easy target for traders with access to central order books. These traders exploit price discrepancies, often leaving liquidity providers with a less favorable asset mix and lower overall value.
The situation is so dire that these were the conclusions of A Recent research paper In this regard:
Our main finding is that profits from fees are lower than the losses experienced by arbitrageurs in the majority of Uniswap's largest pools, which currently contain hundreds of millions of USD. This result raises the question of why limited companies still contribute their capital to these pools.
Other factors, such as hedging, have helped larger operations mitigate those issues, but the extreme conditions described are likely to lead to consolidation of liquidity provision across a smaller number of players.
Why do we care about Ethereum?
Good question, Anon! The reason I bring this up is because much of the recent conversation about MEV on Bitcoin completely ignores the fact that these systems do not exist in a technical vacuum. I realize that new and unknown concepts can raise doubts but many of the dynamics involved are not yet well understood. Looking at it strictly through an artistic lens does us all a disservice.
We realize that various new proposals to improve Bitcoin's scripting capabilities may introduce more expressivity to the protocol. It's not impossible that a combination of these features could allow someone to build the equivalent of an on-chain AMM. Obviously, something the size of Ethereum would have negative implications for Bitcoin's decentralization. We know that MEV tends to stimulate high levels of specialization at the mining level. If you want a better understanding of the risks you're facing, Spiral developer Matt Corallo has put together a good one Primer about this subject.
Unfortunately, the most important aspect of this topic remained more or less ignored by everyone at the table. MEV and every associated system are driven by economic incentives. Different parameters can have a significant impact on the feasibility of this activity.
Our cat story shows how the time interval between blocks plays a crucial role in the game theory of cross-chain auctions. This theory is now supported by Documented evidence. Researchers I generally agree Longer block times exacerbate issues around MEV. This poses a major challenge for anyone considering building AMM systems on the Bitcoin blockchain.
Is Bitcoin in danger?
Comparing Bitcoin's 10-minute block interval to Ethereum's 12 seconds, it's fair to ask whether or not the settlement times required by Proof-of-Work security are consistent across all large-scale on-chain auctions.
The extended time lag between Bitcoin blocks means that liquidity providers (LPs) will be exposed to meaningless prices for long periods, making it impractical, if not irresponsible, to commit significant capital. This latency increases the risk of front-running and other forms of exploitation of light electric vehicles. It's an arbitrage dream!
These observations suggest that online Bitcoin trading may not be viable even if it becomes technically possible. Applications targeting this use case are increasingly improving speed and efficiency, leaving little room for Bitcoin to become a competitive option. Capital allocators will likely avoid the risks associated with this architecture, and users will simply prefer platforms that are more aligned with their interests.
This highlights the critical importance of economic considerations when evaluating the risks and rewards of technical changes to the Bitcoin protocol. Don't get it twisted, the hype surrounding this conversation is driven by economic interests eager to replicate the financial flywheel of MEV atop Bitcoin. Now that the situation has changed regarding innovation at the protocol level, they view this situation as a billion-dollar opportunity to recycle proven business models.
What many fail to appreciate is that Bitcoin's slow but steady settlement process acts as a natural deterrent to predatory MEV activities. This is not a comprehensive study and further evaluation is necessary to assess the risks of MEV on layers built on top of the protocol. On the other hand, this is a very compelling reason to believe that the fear of the MEV monster on Bitcoin may be greatly exaggerated. The inherent delay in the finality of a Bitcoin transaction provides a unique form of protection, making it less vulnerable to the same level of MEV exploitation seen in faster chains like Ethereum.