The closest analogy to illustrating how MEV works is at the forefront. This is an illegal practice in traditional financial markets where a privileged party has access to knowledge of a trade. However, in DeFi and cryptocurrency, front running is commonplace because there’s really no way to regulate it.
Before a trade
is finalized within a block, the entity with knowledge of the trade (a miner) executes a trade before the trade they are aware of.
Since they got their trade first, they have the advantage. Let us illustrate this with a concrete example.
- Trader Joe wants to buy $1,000,000 of ETH using USDT on UniSwap. This could increase the price of ETH by 1%
- Trade Joe starts his trade on UniSwap and waits for it to be confirmed
- Miner Susan takes over the trade and notes that he can buy ETH with USDT before Trader Joe
- Miner Susan places a smaller but still significant trade for $100,000 of ETH knowing that trader Joe will buy ETH right after her.
- Miner Susan arranges transactions in the block so that her transaction is processed before Trader Joe’s
- The block is produced and included in the blockchain, making transactions within it permanent.
- Miner Susan immediately sells her ETH which she just acquired in the previous block after the price increased by 1% from Trader Joe’s trade.
- Miner Susan earned $1,000 (1% of $100k) from trader Joe “front running”
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Front Running in traditional finance
The practice of front running is considered unethical and is illegal in traditional financial markets. The reason is that the entity doing the front running is manipulating the market by exploiting private information that is not available to the public.
This entity has an outsized unfair advantage in the market. Banks, hedge funds and portfolio managers have all been caught red-handed as it is a surefire way of making a profit if it can be made.
MEV and systemic risk
With an understanding of the value extracted from the miner, we can now ask some questions and make some statements about the systemic risk it poses to the systems it takes place on. To begin with, it seems that the MEV is a by-product of transactions included in blocks and blocks produced by entities that can be ethically compromised.
Since miners are anonymous and geographically distributed, regulating their behavior is impossible. This raises the question: can a decentralized exchange exist on a decentralized blockchain without a certain amount of MEV occurring? I don’t think it can. The MEV can be an unfortunate side effect of decentralizing our financial systems to the point where they are impossible to regulate.
After further analysis, we find that entities with the greatest capacity to produce a block simultaneously have the greatest competitive advantage in the market. These are entities with large shares of miners on proof-of-work networks and entities with large amounts of tokens on proof-of-bet networks.
From my perspective, this seems like a systemic risk in blockchain-driven decentralized exchanges. The value in the system can be extracted without the knowledge of the entity or entities from which it is extracted. Adding insult to injury, anyone with a value extracted from them is not aware of what is happening, nor would they have any recourse to recover funds if they were aware of it. Just because they are not aware of it, does not mean that MEV is not wrong, harmful or unethical.
Is there MEV on Bitcoin?
There is no value extracted by the miner on bitcoin, because there are no exchanges that take place on bitcoin. The only thing that the bitcoin network facilitates is transfers. From this point of view, it is simply a settlement level for a single currency, BTC. The bitcoin business and development communities have chosen to scale bitcoin by building peripheral systems for more complex use cases such as decentralized trading. It is their opinion that blockchain is nothing more than a tool to sequence bitcoin transactions and prevent double spending.
Cryptocurrency exchanges such as Kraken, Binance or FTX then build systems that allow people to trade bitcoins in a centralized, but regulated way. The ethic of not allowing frontal racing therefore falls on the companies that manage the exchanges. The application is possible in this case because companies and their operators can be held legally responsible for unethical or illegal financial practices such as front running.
The trade-offs of blockchain-based finance
If we want a decentralized financial system, then we will probably face some level of unethical behavior like MEV. Remember, blockchains are run by miners, and anyone can be a miner. Eventually, individuals, companies, and even governments around the world chose to become miners. What may be illegal in one place, may not be illegal and therefore applicable in another.
There are clear advantages to using blockchain-based financial systems; Low fees, transaction times, and financial independence to name a few. However, these advantages do not come without their trade-offs. They arise from the fact that decentralized systems are decentralized and therefore are difficult, if not impossible, to regulate. We will have to learn to live with some level of unethical behavior if we also want to see a financial world dominated by blockchains.
