Summary

Maximum Extractable Value (MEV), formerly known as Mining Extractable Value, refers to the strategy of including, omitting or reordering transactions when creating a new block. The goal of MEV is to obtain the maximum possible profits. Block producers are best positioned to do this as they have the ability to select and order transactions.

However, other network participants (known as finders) may also pay fees to place trades if they see an MEV opportunity, such as arbitrage, front-running or settlement. MEV is most commonly found in smart contract-enabled networks where blockchain transactions include more complex information.

Introduction

MEV is a crypto term used to describe the deliberate rearrangement, inclusion or exclusion of transactions when producing a new block (to add to a blockchain) in order to extract the largest possible profit. Think of it as additional value being squeezed out of a block, beyond standard rewards and gas fees, and you get it by choosing which transactions to include and in what order.

The MEV has often been associated with the Ethereum network due to its important decentralized finance (DeFi) ecosystem. The more complex the transactions involved in a block—for example, smart contracts connected to borrowing, lending, or trading—the more opportunities block producers will have to make additional profits (extract maximum value) by deciding to include, omit or reorder certain transactions.

What is MEV?

When this concept was first introduced, it was primarily associated with the Ethereum network, which at the time used a Proof-of-Work (PoW) consensus mechanism. In that case, the miners were the ones who had the power to reorder, include or exclude transactions when producing the blocks, and they could make those choices to extract additional value.

This led to the creation of the term "Extractable Mining Value", to explain the phenomenon of this activity. However, in September 2022, Ethereum concluded The Merge stage, a technical update that resulted in the change of the consensus mechanism from PoW to Proof of Stake (PoS).

As a consequence, new blocks on the Ethereum network are no longer created by miners, but by validators. Despite this change, PoS systems are not immune to MEV. Blocks continue to be created, so those who choose which transactions to include and in what order can make decisions that will help them extract as much money as possible from a block. Although the old concept of MEV continues to exist, now the letter M no longer corresponds to Mineros, for the simple fact that it is not exclusive to them. Hence MEV now means Maximum Extractable Value.

How does the MEV work?

Understanding how MEV works requires a basic understanding of the role of block producers (whether miners or validators). They play a critical role in securing and maintaining blockchain networks and are responsible for verifying transactions and adding them to the network as blocks. Depending on each chain, this process is known as mining or validation.

Simply put, block producers guarantee the integrity of transactions on the network and ensure that it continues to function. Without them, no new data could be added to the chain. Block producers are those who collect data from user transactions and organize it into blocks to add to the network chain.

The important thing here is that it is up to the block producers which transactions to include in their blocks. Logically, transactions are chosen based on their profitability, which means that those with the highest fees will be the first to be selected. It is for this reason that users pay higher gas fees (or transaction fees) during the busiest periods of activity, to ensure that their transactions are the first to be chosen. If a block producer selects the transactions with the highest fees, a greater profit will be made. Consequently, transactions with lower fees will have to wait longer to be included in a block.

However, there is no rule that trades must be selected or ordered based on fees. When transactions include more complex information (such as in smart contract-powered blockchains), block producers can include, exclude, or reorder transactions to earn additional profits beyond standard block rewards and fees.

For example, selecting certain transactions over others and ordering them in a particular way can provide additional profits due to arbitrage opportunities generated or on-chain settlement. This is the essence of MEV: the process of selecting and ordering transactions to increase financial return.

SEM finders

Although it may seem that the MEV strategy favors only block producers, a significant amount of MEV is generated by other participants, known as "seekers." These participants use specific MEV operations that analyze network data for profitable MEV opportunities.

Finders typically pay extremely high gas fees to block producers to ensure profitable MEV transactions and strategies are executed. Depending on the competition for an MEV opportunity, a block producer may receive gas commissions of up to 99.99% of a seeker's potential profit.

As an example, let's take decentralized exchange (DEX) arbitrage where search engines are known to pay over 90% of their MEV revenue in gas fees. They do this because it is the only way to ensure that a profitable arbitrage trade is executed before other similar trades.

Common Examples of MEV

Arbitrage, front-running and liquidation offer opportunities to finders and block producers who want to make profits from MEV. Below, we take a closer look at these examples to provide a better understanding of what MEV is and how it works.

Arbitration

When the price of an asset is not consistent across exchanges, an arbitrage opportunity immediately arises. In the crypto space, the same token could be valued differently on two different DEXs. When someone spots this (known as an arbitrageur), they will move to make a trade and take advantage of this discrepancy. MEV occurs when a search bot identifies the pending transaction and inserts its own transaction before it to extract the value offered by the arbitrage opportunity.

Front-running

Block finders and producers can take advantage of their ability to order transactions in a block to advance a significant purchase order that is still pending in the transaction pool. The MEV happens when a similar buy order is inserted before that trade in order to secure a more favorable price before the large buy order passes, which would increase the price of that digital asset.

A similar MEV strategy is “sandwiching,” which involves entering a buy order before and a sell order after a specific transaction that will generate price movements. In this way, price pressure from both sides is taken advantage of.

Settlements

DeFi allows users to take out loans against digital assets deposited as collateral. If the market moves and the value of the security falls below a certain price, that position is liquidated. The smart contracts involved often pay a reward or commission to the transaction that triggers settlement.

There is an MEV opportunity here for any finder or block producer who runs bots to detect these types of transactions, and who can insert their own settlement transaction into the block before someone else, allowing the reward value to be extracted.

Conclusions: advantages and disadvantages of MEV

The MEV is a rational strategy, since those who participate in it mainly try to maximize their profits. Some may argue that it benefits the ecosystem as a whole by ensuring that deficiencies are corrected as quickly as possible.

For example, MEV seekers competing to be the first to capture value from arbitrage opportunities makes for rapid price corrections on DEXs. Likewise, lending protocols do not want risky loans to spiral out of control if collateral levels become unbalanced, so MEV's liquidation drive leads to lenders receiving their payback as soon as possible.

However, the MEV also presents a number of problems that should not be ignored. Some implementations, such as front-running and sandwiching, produce poor results for other users who are forced to pay their trades at a higher price, suffer greater slippage, or lose value in what is essentially a "zero-sum game." or zero sum game.

Additionally, the activity of MEV seekers can lead to higher gas prices and network congestion as they compete to insert their transactions into blocks to capture the resulting value.

At a fundamental level, if the value of reordering transactions in a previous block is greater than the rewards and fees of the next block, the MEV could make it economically rational for a block producer to commit to network reorganization. This would threaten the consensus and integrity of the network.

As the ecosystem continues to rapidly evolve, finding solutions to these MEV-related problems is now a core area of ​​research and development in the space.

Further reading

• Ethereum's The Merge update: everything you need to know

• What is a Decentralized Exchange (DEX)?

• Proof of Work (PoW) vs. Proof of Stake (PoS)