Summary
Maximum Extractable Value (MEV), formerly known as Miner Extractable Value, refers to the strategy of adding, removing, or reordering transactions when creating a new block. MEV aims to earn as much extra profit as possible. Block producers are best suited to this strategy because they have the ability to select and order transactions.
However, other network participants (also called searchers) can also pay a fee to sort transactions if they find MEV opportunities (such as arbitrage transactions, front-running transactions, or forced liquidation transactions). MEV is common in networks that support smart contracts, where blockchain transactions contain more complex information.
Introduction
MEV is a cryptocurrency term used to describe the deliberate addition, deletion, or reordering of transactions in order to maximize profit when generating a new block (to be added to a blockchain). You can think of it as squeezing extra value out of a block beyond the standard reward and gas fees by choosing which transactions to add in what order.
MEV is often associated with the Ethereum network because Ethereum has an extremely important decentralized finance (DeFi) ecosystem. The more complex the transactions involved in a block (for example, smart contracts related to lending or trading), the more opportunities there are for block producers to make extra profits (extracting maximum value) by deciding to add, delete, or reorder certain transactions.
What is MEV?
When the concept of MEV was first introduced, it was mainly associated with the Ethereum network, which used the Proof of Work (PoW) consensus mechanism. Therefore, miners have the right to reorder or add or delete transactions when producing blocks, and can use these choices to squeeze out additional value.
The term "miner extractable value" came into being to explain this phenomenon of extracting as much extra profit as possible. However, in September 2022, Ethereum completed the merger, a technical upgrade that converted the consensus mechanism of the Ethereum network from PoW to Proof of Stake (PoS).
As a result, new blocks on the Ethereum network are no longer created by miners, but by validators. However, PoS systems are not immune to MEV. Since blocks are still being created, whoever chooses which transactions to add in what order will make decisions that will extract as much profit as possible from the block. While the old MEV concept still exists, it now represents the maximum extractable value because it is no longer exclusive to miners.
How does MEV work?
To understand how MEV works, you need to have a basic understanding of the role of block producers, whether miners or validators. Block producers play a vital role in protecting and maintaining blockchain networks. They are responsible for verifying transactions and adding them to the network in the form of blocks. Depending on the blockchain, this process is called mining or verification.
In short, block producers guarantee the integrity of transactions on the network and ensure that it continues to operate. Without block producers, new data cannot be added to the blockchain. Block producers are responsible for collecting user transaction data and organizing it into blocks to be added to the network chain.
It is important to note that which transactions are added to a block is determined by the block producers. Logically, block producers select transactions based on profitability, which means that transactions with high transaction fees will be selected first. This is why users pay higher gas fees (or transaction fees) during busy times to ensure that their transactions are selected first. If block producers select transactions with the highest transaction fees, they will make more profit. Therefore, transactions with lower transaction fees will have to wait longer before being added to a block.
However, there is no requirement that transactions must be selected or ordered based on transaction fees. When transactions contain more complex information (as they do in blockchains that support smart contracts), block producers can add, remove, or reorder transactions to earn additional profits beyond the standard block reward and transaction fees.
For example, block producers who choose certain transactions over others and order them in a particular way may earn additional profits from the resulting arbitrage opportunities or forced liquidation of transactions on the chain. The essence of MEV is the process of selecting and ordering transactions to gain more economic benefits.
MEV Seeker
While MEV appears to be a strategy that benefits only block producers, in fact, a large amount of MEV is obtained by other participants, who are called “seekers.” These participants use operations targeting MEV to analyze network data to find MEV profit opportunities.
Seekers often pay extremely high gas fees to block producers to ensure their MEV-profitable transactions and strategies are executed. Reasonably speaking, depending on the competition for MEV opportunities, block producers can receive up to 99.99% of the searcher's potential profit in gas fees.
Taking decentralized exchange (DEX) arbitrage as an example, it is well known that searchers tend to pay more than 90% of their MEV income in gas fees on such platforms, as this is the only way to ensure that profitable arbitrage trades are executed before similar trades.
Common Examples of MEV
Arbitrage trading, front-running, and forced liquidation all provide opportunities for searchers and block producers to profit from MEV. Below we will take a closer look at these examples to provide a detailed understanding of what MEV is and how it works.
Arbitrage Trading
Arbitrage opportunities arise when the price of an asset is inconsistent across trading platforms. In the cryptocurrency space, the same token may be priced differently on two different DEXs. When someone (an arbitrageur) discovers this, they will take action to trade to profit from this pricing difference. MEV is generated when a seeker's bot identifies a pending transaction and inserts its own transaction before it to extract the value provided by this arbitrage opportunity.
Front-runner trading
Searchers and block producers can use their ability to sort transactions in a block to preempt an important buy order that is still waiting to be executed in the transaction pool. When a similar buy order is inserted before this transaction to obtain a more favorable price before the large buy order passes, MEV is generated, which will increase the price of the digital asset.
A similar MEV strategy is a "sandwich" strategy, which places a buy order before a specific price movement trade and a sell order after that trade, thereby taking advantage of price pressure from both sides.
Forced liquidation transaction
DeFi allows users to take out loans using deposited digital assets as collateral. If the market fluctuates and the value of the collateral falls below a certain price, the position will be forced to close. The smart contracts involved usually pay rewards or fees to the transactions that trigger the forced liquidation.
This creates a MEV opportunity when any searcher or block producer running a bot discovers such a transaction and can insert their own forced liquidation transaction into the block before anyone else, thereby extracting the reward value.
Conclusion: Advantages and Disadvantages of MEV
Since MEV participants are primarily motivated by profit maximization, MEV is a rational strategy. Some would argue that MEV benefits the entire ecosystem by ensuring that inefficiencies are corrected as quickly as possible.
For example, MEV searchers compete to be the first to extract value from arbitrage opportunities, which can lead to rapid price corrections between DEXs. Similarly, if collateral levels are out of balance, lending protocols do not want risky loans to go unchecked, so driving MEV forced liquidations will force lenders to get their funds repaid as soon as possible.
However, MEV also brings some problems that cannot be ignored. Some implementations such as front-running and sandwich attacks will have a negative impact on other users, who are forced to pay excessive fees in transactions, suffer higher slippage, or face value losses in what is essentially a zero-sum game.
Additionally, the activity of MEV seekers competing to insert their transactions into blocks to capture the resulting value could lead to higher gas prices and network congestion.
Essentially, if the value of reordering transactions in the previous block is higher than the rewards and transaction fees provided by the next block, it is economically reasonable for block producers to commit to blockchain reorganization in order to obtain MEV profits. However, this threatens the consensus and integrity of the network.
As the blockchain ecosystem continues to rapidly evolve, finding solutions to these MEV-related issues has now become a core area of research and development within the field.
Further reading
A comprehensive introduction to Ethereum merge upgrades
What is a decentralized exchange (DEX)?
Proof of Work (PoW) vs. Proof of Stake (PoS)