Maximal Extractable Value (MEV) Supply Chain and why we invested in Blink Labs.

Exploring the dynamics of decisions, intentions, and incentives that led to the emergence of MEV. We're also excited to announce our investment in Blink Labs.

Water is a classic example of a scarce resource with alternative uses. The scarcity of water becomes apparent, particularly in regions facing drought, where the competing needs for agricultural, industrial, and domestic use become more evident, and the allocation of water to different uses becomes a significant economic and social challenge.

If everything were unlimited, we wouldn't need to be careful about the way we use our resources and everyone could afford a private jet. Society distributes resources according to the merit of the market participants. If an entity provides more value, society grants them greater access to resources.

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The quality of resource allocation decisions plays a crucial role in determining the wealth and prosperity of an economy. This is why some nations, despite having abundant natural resources, may be considered poor, while others, with fewer resources, can thrive economically through effective resource allocation.

Cryptoeconomics utilizes principles from economics to manage resources and incentives in blockchain networks. It essentially involves the application of cryptography and incentive mechanisms to create efficient cryptoeconomic systems.

The design decisions in a cryptoeconomic system need to ensure that the outcome is going to be a decentralised, secure, and self-regulating system. The quality of these decisions is pivotal in shaping stakeholder incentives.

These incentives in the form of rewards and penalties ensure that participants contribute positively to the network's security and stability. In blockchain environments, where systems are decentralized, properly designed incentives are vital.

Economics of Ethereum

Let’s take the example of a self-regulating cryptoeconomic system like Ethereum. The core product offered by Ethereum is the blockspace on its blockchain. The blockspace is used to record transactions and store other data, and the Ethereum network wants to ensure that the blockspace is used efficiently, a sign of efficient utilization would be increased economic activity within the Ethereum ecosystem.

In an economic system, the incentives that come into play subsequent to a decision significantly influence both the intended outcome and the behavior of participants in that economy. Good intentions don't always lead to favorable outcomes. The end result of a decision could be very different from its intended goal. Incentives often outweigh intentions, potentially leading to unintended consequences from even well-intentioned decisions; for better or worse, incentives drive the world.

Ethereum took the design decision to keep the mempool public. Mempool is a list of pending transactions that have been broadcasted to the Ethereum network and are waiting to be included in a block. Mempool data in Ethereum is open and publicly available to the entire network, meaning that anyone can see the transactions occurring in real time before they are added to the blockchain. Here is what the Ethereum mempool looks like.

The intention behind the Ethereum community’s decision to make a public mempool could have been to build a transparent, decentralised system but as an unintended consequence of that decision; arbitrage like front-running became possible on the Ethereum network.

Front-running in this context refers to the practice where entities observe pending transactions in the mempool and execute their own transactions beforehand, taking advantage of the information about impending trades.

The Ethereum community also took decisions like the switch to Proof of Stake (PoS) and implementation of Ethereum Improvement Proposal 1559 (EIP-1559). PoS replaced miners with validators, who are responsible for validating transactions and maintaining the blockchain. Validators must stake ETH(cryptocurrency of the Ethereum network) as collateral to participate and earn validator rewards, creating a financial commitment to the network's security. Ethereum's PoS system has a fixed annual reward pool, distributed among all validators. This pool doesn't grow with the number of validators; it remains constant. As more validators join the network, this fixed reward pool is split among more participants. As a result, the share of rewards each validator receives decreases.

EIP-1559 introduced a base fee per block which is adjusted based on network demand. The base fee is burned, reducing the overall ETH supply. It also introduced the concept of tips, allowing users to optionally pay extra to validators for prioritizing their transactions in the Ethereum network. These tips in addition to the validator rewards increase the overall yield for staking ETH. This process establishes a connection between the Ethereum blockspace demand and staking returns.

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What is Maximal Extractable Value (MEV), and how does it impact economic activity on the Ethereum blockchain?

Maximal Extractable Value (MEV) refers to the maximum value that can be extracted by reordering or inserting the transactions in a block. It is estimated that approximately $675 million of MEV profit has been realized between December 2019 and September 2022 on the Ethereum blockchain network¹.

In 2022, MEV bots demonstrated their considerable impact by generating revenue exceeding $307 million specifically within the Ethereum ecosystem². Among these, arbitrage transactions contributed a noteworthy $145 million to their total revenue, while sandwich attacks – a strategic maneuver in the realm of MEV – brought in an additional $128 million.

MEV arises from various activities on the Ethereum blockchain, with Decentralized Finance(DeFi) being a major contributor. DeFi refers to financial services like lending, borrowing, and trading that operate on blockchain technology without requiring central authorities like banks. When a user places a market order to buy or sell a significant amount of a token at a decentralized exchange like Uniswap, it can deplete the liquidity at the current price level. If there isn't enough liquidity in the pool to fulfill the entire order at the current price, the price may start to shift. To complete the user's order, the decentralized exchange will execute the trade at progressively worse prices as it moves through the order book to access available liquidity.

When arbitrageurs observe this price difference, they can take advantage of it by buying ETH at a lower price on other exchanges and selling it on Uniswap at a higher price, profiting from the price difference. As arbitrageurs execute these trades, they help rebalance the price on Uniswap by increasing liquidity and reducing the price difference between Uniswap and other exchanges.

This arbitrage activity helps in rebalancing the market by restoring prices to levels consistent with other exchanges. This process is a key mechanism that keeps decentralized exchange prices in line with the broader market.

To ensure the successful processing of their transactions, arbitrageurs prioritize them by paying elevated transaction fees, comprising both a fixed base fee and tips. These tips go to validators and increase their yield. This dynamic also implies that the more vibrant the DeFi sector becomes, the higher the potential for MEV, which, in turn, can have a positive impact on stakers' yield rates.

MEV also enhances the efficiency of DeFi lending. Lending protocols rely on swift liquidations when borrowers' collateral drops below required levels to ensure lenders are reimbursed. Informed actors who can identify and rectify inefficiencies play a crucial role in this process, as they can claim rewards offered by these platforms. Without such participants actively addressing market imbalances, the resilience and efficiency of DeFi lending protocols may not attain their current levels.

When DeFi activity on Ethereum increases, staking yield increases which creates incentives for market participants to stake ETH. As more and more ETH is staked the network staking reward per validator decreases. When the staking yield for ETH decreases, some of the staked ETH could move to DeFi platforms in search of higher returns thereby increasing economic activity on the Ethereum network.

MEV plays a pivotal role, serving as a conduit linking DeFi activities to ETH yield rates, effectively facilitating the transfer of value from arbitrageurs to stakers. The relationship between MEV activities and staking rewards creates a dynamic feedback loop, where increased DeFi activity heightens the potential MEV, which leads to higher validator rewards, thereby incentivizing greater participation in the Ethereum network. These mechanisms collectively form a self-regulating system, balancing Ethereum's economy without the need for external intervention.

Who are the different stakeholders in the MEV supply chain of Ethereum?

In Ethereum, validators have the option to access MEV rewards either directly or through the MEV-Boost mechanism. Validators running the MEV-Boost client software can maximize their staking rewards by selling blockspace to an open market of block builders. Validators can request blocks from various relays through MEV-Boost, which in turn requests blocks from a network of builders, providing the most profitable block to the validator. Let's take a closer look at the roles and functions of searchers, builders, relays, and other components within the MEV-Boost mechanism.

• Searcher: An entity or an algorithm that continuously scans the list of pending transactions and looks for scenarios where they could benefit by applying various MEV extraction strategies.

• Bundles: A collection of transactions reordered and submitted together for inclusion in a block.

• Block: Blocks are batches of transactions with a hash of the previous block in the chain.

• Builders: A block builder batches the transactions together and sends the block to the relay.

• Relay: Once builders put together blocks with the available transactions, they send them to relays. Relays will keep the transactions in a block private until a validator commits to including the block in their chain. Validators can view the block header before committing to include a block.

• Validator: Receives a proposed block from a relay, adds its digital signature to validate the block, and then proposes the signed block to the PoS network for consideration and inclusion in the blockchain.

How does value trickle down in the MEV supply chain?

• Between June 11th and July 11th, 2023, MEV searchers extracted $20.45 million from users' transactions via wallets and RPCs.

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• Out of the $20.45M, $3.74M was burnt for EIP-1559.
• Searchers collected a $4.98 million share and transferred $10.94 million to builders through MEV-Boost.
• Builders received a $1.54 million share and forwarded $9.29 million to validators.
• Another $7.14M out of the $20.45M was sent to validators directly without MEV-Boost.
• Profit distribution:
  • Searchers — $4.98M
  • Builders — $1.54M
  • Validators — $16.43M

How does MEV appear in blockchain?

MEV emerges in the blockchain from the activities of certain market participants who strategically position transactions in a block by prioritizing, rearranging, or inserting them to extract additional value from block production. Here are some examples of how MEV is extracted:

• DEX Arbitrage: This process entails MEV bots capitalizing on price disparities between two decentralized exchanges (DEXs) to generate profits. For instance, when Token A is priced lower on DEX A than on DEX B, an MEV bot seizes the opportunity by buying Token A on DEX A and subsequently selling it on DEX B, thereby exploiting the price difference to its advantage.
• Sandwiching: This trading strategy involves a trader strategically placing buy and sell orders in proximity to a substantial blockchain transaction. The idea is to capitalize on the price movement caused by the large transaction. Typically, the first order (buy) is placed just before the large transaction, with the anticipation that this transaction will drive the price up. The second order (sell) is placed right after, to sell at the now higher price. This strategy leverages the ability of the trader or bot to influence the order in which transactions are added to a block.
  • Pending transactions are visible to everyone within the public mempool.
  • For instance, let's consider Alice, who initiates a transaction (Tx5) to purchase 500 X tokens through Uniswap.
  • Upon observing Alice's transaction in the mempool, Bob takes action by creating two new transactions: Tx41 (to buy 500 X tokens) and Tx61 (to sell 500 X tokens).
  • Bob bundles these transactions and submits them to the builder, attaching a tip for their inclusion.
  • Ultimately, Bob reaps profits by strategically buying low and selling high as part of this trading approach.

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• Liquidations: Platforms like Compound and Aave are susceptible to the actions of liquidation front-runners. These independent network participants, known as searchers, have the ability to identify and exploit front-running techniques when it comes to liquidation transactions. This enables them to secure the liquidator fee or take advantage of discounts on the collateral involved.

Negative Impacts of MEV

MEV introduces the potential for practices like front-running and sandwich attacks, where users' transactions are exploited for profit, ultimately creating unfair trading conditions within DeFi platforms. This can give rise to concerns about fairness, as it empowers certain market participants with advanced capabilities, to exploit market inefficiencies at the expense of regular users.

Users may face unpredictability in transaction execution and pricing, which can be particularly detrimental for smaller or less experienced participants. These regular users may experience adverse effects, including heightened transaction fees, unpredictable transaction inclusion times, and a less transparent and predictable transaction ordering process.

Addressing these MEV-related challenges is a central focus of ongoing research. Meanwhile, some companies are developing advanced solutions aimed at restoring equilibrium and ensuring efficient transaction execution for users. For instance, Blink Labs stands out as a notable example in this arena, dedicating its efforts to creating robust MEV protection, recovery mechanisms, and gas rebate strategies.

Why We Invested in Blink Labs

At Blockwall, we have been monitoring the growth of the MEV ecosystem closely and we anticipate that Blink Labs with its strong partnerships and stellar team will become a potential market leader. We decided to invest in Blink Labs for several compelling reasons. Firstly, their innovative Go-to-Market strategy is more practical and requires no change in user behavior. Their integration of MEV protection in the background serves as the ideal Go-to-Market approach. By creating a private order book tailored for transactions originating from applications like wallets or exchanges, Blink Labs establishes a win-win scenario.

Moreover, their unique approach involves bundling and selling user floats directly from wallets, creating a mutually beneficial situation. This provides an additional revenue source for wallets and offers users enhanced trade execution. In return, Blink Labs earns a share of the processed volume, solidifying its value proposition. The current and future potential of the MEV market adds to our confidence in Blink Labs. The MEV market's growth trajectory is closely tied to the expansion of economic activities on the blockchain. Given its inherent connection to blockchain activities, MEV is poised to flourish in the coming years.

Another factor that bolsters our investment decision is the strength of Blink Labs' team. The co-founder and CEO, Yaniv Neu-Ner, brings invaluable experience to the table. His history of founding and selling a multi-party computation (MPC) custody business to Gemini, followed by his role as Director of Business Development at Gemini, showcases his expertise. Co-founder and CTO Ciaran McVeigh, on the other hand, contributes substantial knowledge in infrastructure management. His prominent role as the head of infrastructure at 0xA staking, along with his contributions at ConsenSys and Elliptic, adds to the team's prowess.

We firmly believe that the MEV market will continue its expansion in tandem with the increasing economic activities on the blockchain. Blink Labs' ingenious solution, which seamlessly integrates within transaction origination sources, stands out due to its practicality. Importantly, it doesn't necessitate a shift in user behavior, making it a more feasible approach. Given its strategic partnerships with major wallets and other transaction originators, Blink Labs is well-positioned to lead the category.

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References:

1. https://explore.flashbots.net/
2. https://eigenphi.substack.com/p/mev-outlook-202
3. https://www.bankless.com/ethereums-economic-engine
4. https://usa.visa.com/solutions/crypto/cryptoeconomics.html