What is MEV?
For the uninitiated, maximum extractable value (MEV) involves various techniques used by market players to capture additional value by exploiting pricing inefficiencies in blockchain transactions.
A naive form of MEV is called “transaction sniper”.
More recently, manifestations of this phenomenon have begun to populate local bitcoin memepools due to ordinal trading. Without going into too much detail, the way on-chain trading currently works is through the use of pre-signed bitcoin transactions (PSBT).
The concept is simple: some users post images on a marketplace by putting together a transaction with the details and price at which they would like to sell them. You, a cat fan, can purchase this feline grail by completing the transaction, adding your address, transaction fees, and your signature. The transaction is then broadcast and finally settled on the bitcoin network.
Easy, right?
Not so.
It turns out that cats are a hot commodity these days and other fellow cat-lovers are eyeing your prize. The open nature of the offers allows any of them to interfere with your purchase. This is because PSBT listings are auctions, not exclusive sales. Every transaction in the mempool associated with a cat is up for bid. bitcoin's 10-minute blocking interval opens a window for opportunistic cats to “raid” each other's transactions in search of the most valuable pieces. Nothing is settled until a transaction becomes a block.
From this we learn that on-chain auctions are vulnerable to the settlement time of the blockchain on which they are settled. This creates an especially thorny problem for anyone with a little more ambition than exchanging cat photos.
What is causing FSM?
Now, what's the problem with MEV? Surely not everyone is up in arms because a bunch of degens are outdoing each other for cat photos?
Answering this question requires opening a whole new can of worms. This is going to be a trip into shit land, but bear with me, I promise it's worth it.
You see, MEV is a big business. To give a rough idea, MEV-Boost, the software responsible for coordinating the mining of MEV on ethereum, has distributed, in less than 2 years, about 500,000 eth in rewards. That's almost 2 billion dollars!
What drives this entire market is, of course, trade. (read: degenes)
On-chain AMMs (Automated Market Makers) use a popular concept called liquidity pools to allow users to trade assets without relying on centralized order books. Pools are usually made up of a pair of assets, such as ethereum and USDC.
When users want to exchange one asset for another, they interact with these liquidity pools. Each trade adjusts the proportion of the two assets in the pool, affecting their relative prices. By eliminating centralized order books where a buyer must match a seller for each trade, AMMs can be implemented as a decentralized on-chain contract.
Once a trading pair is created, any user can trade against the pool or provide liquidity to it. Contributing liquidity involves supplying one or both assets to the group, ensuring that it maintains the appropriate proportion. Any imbalance creates an opportunity for market makers to engage in arbitrage by buying the cheapest asset in the pool and selling it at a higher price elsewhere, such as centralized exchanges. This activity, along with the fees accrued by liquidity providers (LPs) for trading activity, incentivizes people to keep these markets liquid.
If you've heard of DeFi or Uniswap but never looked into them, this is the secret sauce. Liquidity pools can be deployed to trade any asset and their permissionless nature has made them wildly popular. Upon closer inspection, we can see that these exchanges are not fundamentally different from the cat market we discussed above: they are just chain auctions.
As you can imagine, ethereum's architecture and its additional programmability create a particularly fertile environment for those auctions to be abused and manipulated.
Perhaps the most popular and intuitive is front running. Please remember that AMM trades are not settled instantly. In the same way that sniper cats can monitor the bitcoin mempool for juicy deals, ethereum also has an army of financial mercenaries diligently keeping an eye on every trading opportunity.
Except the eth guys aren't messing around with this stuff. It's not Private Ryan, it's SEAL Team Six that's there. They employ several elaborate techniques to exploit the time interval between the time a transaction is transmitted and the time it is confirmed on the blockchain. As a result, early adopters can place their own trades ahead of the original trade, benefiting from the price changes caused by their actions. This usually results in regular users receiving worse than expected prices. One of the worst manifestations of this is the practice of user sandwiching, where a buy order is placed just before a user's trade and a sell order immediately after, capturing the price difference at the expense of the original trader.
While those dynamics have been controversial due to the effect they have on the user experience, they only represent one part of the MEV economy. He x.com/CoWSwap/status/1757783806273360376″>major source of MEVby a fairly wide margin, comes from something commonly known as “Loss versus rebalancing.” Simply put, it is an adverse form of the 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 cannot adapt to inter-block market volatility. Due to their exposure to outdated prices, they become an easy target for traders with access to centralized order books. These traders exploit price discrepancies, often leaving liquidity providers with a less favorable asset mix and reduced overall value.
The situation is so serious that these were the conclusions of a recent research work on the matter:
Our main result is that commission profits are smaller than arbitrageur losses in most of the largest Uniswap pools, which currently hold hundreds of millions of dollars. This result raises the question of why LPs contribute their capital to these funds.
Other factors, such as hedging, have helped larger operations mitigate those issues, but the extreme conditions described have likely resulted in the consolidation of liquidity provisioning across a smaller number of players.
Why do we care about ethereum?
Good question, anonymous! The reason I mention this is because much of the recent talk about MEV in bitcoin completely overlooks the fact that such systems do not exist in a technical vacuum. I understand that new and unfamiliar concepts can cause skepticism, but many of the dynamics involved are already well understood. Looking at it strictly from a technical perspective is doing us all a disservice.
We understand that the various new proposals circulating to improve bitcoin's scripting capabilities may introduce more expressiveness to the protocol. It's not impossible that a combination of those features would allow someone to build the equivalent of an on-chain MMA. It is clear that something on the scale of ethereum would have adverse effects on bitcoin's decentralization. We know that MEV tends to encourage high levels of specialization at the mining level. If you want to better understand the risks involved, Spiral developer Matt Corallo put together a decent report. bitcoin.ninja/2024/04/16/stop-calling-it-mev/”>primer in the subject.
Unfortunately, the most important aspect of this issue has been more or less completely ignored by everyone at the table. MEV and all associated systems are driven by economic incentives. Different parameters can have a significant impact on the viability of this activity.
Our story about cats illustrates how the interval between blocks plays a crucial role in the game theory of on-chain auctions. This theory is now supported by documented evidence. Researchers x.com/0x94305/status/1793050957003333771″>generally agree that longer blocking times exacerbate MEV-related problems. This poses a major challenge for anyone considering building AMM systems on the bitcoin blockchain.
Is bitcoin in danger?
Comparing bitcoin's 10-minute blocking interval to ethereum's 12 seconds, it's fair to ask whether the settlement times required by Proof-of-Work security are supported across all large-scale on-chain auctions.
bitcoin's long block interval means that liquidity providers (LPs) would be exposed to stale prices for extended periods, making it impractical, if not irresponsible, to commit substantial capital. This latency increases the risk of front-end execution and other forms of MEV exploitation. It's a refereeing dream!
Those observations suggest that bitcoin on-chain trading may not be viable even if it becomes technically possible. Applications targeting this use case are becoming increasingly optimized for speed and efficiency, leaving little room for bitcoin to become a competitive option. Those allocating capital are likely to avoid the risk associated with this architecture, and users will simply prefer platforms better 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. Make no mistake, the noise surrounding this conversation is driven by economic interests eager to replicate MEV's financial flywheel on bitcoin. Now that the attitude towards innovation at the protocol level has changed, they see this situation as a multi-billion dollar opportunity to recycle proven business models.
What many fail to appreciate is that bitcoin's slow but steady liquidation process acts as a natural deterrent to MEV's predatory activities. This is not a comprehensive study and further evaluation is necessary to assess MEV risks in layers built on top of the protocol. On the other hand, it is a pretty compelling reason to believe that the fear of the MEV monster in bitcoin may be wildly overrated. bitcoin's inherent transaction finality delay offers a unique form of protection, making it less susceptible to the same level of MEV exploitation seen on faster chains like ethereum.
