TL;DR
Maximal Extractable Value (MEV) — previously known as Miner Extractable Value — refers to a strategy to include, omit, or reorder transactions when making a new block. The goal of MEV is to make as much additional profit as possible. Block producers are best placed to do this as they have the ability to select and order transactions.
However, other network participants (known as searchers) can also pay fees to place transactions should they see a MEV opportunity, such as arbitrage, front-running, or liquidation. MEV is most often found in smart contract-enabled networks where blockchain transactions include more complex information.
Introduction
MEV is a crypto term used to describe the deliberate reordering, inclusion, or exclusion of transactions when producing a new block (to be added to a blockchain) in order to extract as much profit as possible. Think of it as the extra value squeezed out of a block beyond the standard reward and gas fees by choosing which transactions to include, and in which order.
MEV has most often been associated with the Ethereum network due to its significant decentralized finance (DeFi) ecosystem. The more complex the transactions involved in a block are — for example, smart contracts connected with lending, borrowing, or trading — the more opportunities there will be for block producers to make extra profit (extract maximum value) by deciding to include, omit, or reorder certain transactions.
What Is MEV?
When this concept was first introduced, it was mostly associated with the Ethereum network, which used a proof-of-work (PoW) consensus mechanism at the time. As such, miners were the ones with the power to reorder, include, or exclude transactions when producing blocks, and could make these choices to squeeze out extra value.
This led to the term Miner Extractable Value being coined to explain the phenomenon of this extraction of as much extra profit as possible. However, in September 2022, Ethereum finalized The Merge, a technical upgrade that switched the network’s consensus mechanism from PoW to proof-of-stake (PoS).
As such, new blocks on the Ethereum network are no longer created by miners but by validators. PoS systems aren’t immune to MEV, however. Blocks are still being created, so whoever chooses which transactions to include, and in what order, can make decisions that will help them to extract as much money from a block as possible. While the old MEV concept still exists, it is now said to stand for Maximal Extractable Value, since it’s no longer exclusive to miners.
How Does MEV Work?
Understanding how MEV works requires a basic understanding of the role of block producers (be they miners or validators). They play a crucial role in securing and maintaining blockchain networks, and are responsible for verifying transactions and adding them to the network in the form of blocks. Depending on the specific chain, this process is known either as mining or validation.
Simply put, block producers guarantee the integrity of transactions on the network and ensure it continues to function. Without them, no new data can be added to the chain. Block producers are the ones who collect user transaction data and organize them into blocks to be added to the network chain.
The important thing to note is that it’s up to the block producers which transactions to include in their blocks. Logically, transactions are chosen based on profitability, which means those with the highest fees attached to them will be selected first. This is why users pay higher gas fees (or transaction fees) during busy periods — to ensure their transactions are selected first. If a block producer selects the transactions with the highest fees, they will make a bigger profit. Consequently, transactions with lower fees have to wait longer to be included in a block.
However, there is no rule that dictates transactions must be selected or ordered based on fees. When transactions include more complex information (as they do in smart contract-enabled blockchains), block producers can include, exclude, or reorder transactions so as to make extra profit beyond the standard block rewards and fees.
For example, selecting certain transactions over others and ordering them in a particular way may allow for additional profits due to resultant arbitrage opportunities or on-chain liquidation. This is the essence of MEV: the process of selecting and ordering transactions for further financial gain.
MEV searchers
While it seems like MEV is a strategy that solely benefits block producers, a significant amount of MEV is secured by other participants, known as “searchers”. These participants use MEV-specific operations that analyze network data in search of profitable MEV opportunities.
Searchers typically pay extremely high gas fees to block producers to ensure their profitable MEV transactions and strategies are executed. Rationally, depending on the competition for an MEV opportunity, a block producer can receive gas fees of up to 99.99% of a searcher’s potential profit.
Take decentralized exchange (DEX) arbitrage, for example, where searchers have been known to pay more than 90% of their MEV income in gas fees — they do so as it’s the only way to ensure a profitable arbitrage trade is executed ahead of similar trades.
Common Examples of MEV
Arbitrage, front-running, and liquidation all offer opportunities to searchers and block producers seeking to profit through MEV. Below, we take a closer look at these examples to provide a more detailed understanding of what MEV is and how it works.
Arbitrage
When the price of an asset isn’t consistent across exchanges, there is immediately an arbitrage opportunity. In the crypto space, the same token could be priced differently on two different DEXs. When this is spotted by someone (an arbitrageur), they will move to make a trade to profit from the discrepancy. MEV takes place when a searcher’s bot identifies the pending transaction and inserts their own transaction ahead of it in order to extract the value offered by that arbitrage opportunity.
Front-running
Searchers and block producers can take advantage of their ability to order transactions in a block to front-run a significant buy order that’s still pending in the transaction pool. MEV occurs when a similar buy order is inserted ahead of that trade in order to secure a more favorable price before the large buy order goes through, which would increase the price of that digital asset.
A similar MEV strategy is “sandwiching”, which entails placing a buy order before and a sell order after a specific price-moving transaction, thereby taking advantage of the price pressure from both sides.
Liquidations
DeFi allows users to take out loans against deposited digital assets as collateral. If the market moves and the value of the collateral drops below a certain price, that position is liquidated. The smart contracts involved often pay out a reward or fee to the transaction that triggers the liquidation.
An MEV opportunity exists here for any searcher or block producer running bots to spot this kind of transaction, and who are then able to insert their own liquidation transaction in the block ahead of anyone else, thereby extracting the reward value.
Closing Thoughts: The Pros and Cons of MEV
MEV is a rational strategy as those engaging in it are mainly trying to maximize their profits. Some would argue that it benefits the wider ecosystem by ensuring that inefficiencies are corrected as quickly as possible.
For example, MEV searchers racing to be the first to capture value from arbitrage opportunities results in speedy price corrections across DEXs. Similarly, lending protocols don’t want risky loans going unchecked should collateralization levels become unbalanced, so the MEV liquidation push leads to lenders being repaid as soon as possible.
However, MEV also presents a number of issues that mustn’t be ignored. Some implementations, such as front-running and sandwiching, produce bad outcomes for other users, who are forced to overpay on their trades, suffer from greater slippage, or lose out on value in what is essentially a zero-sum game.
Additionally, MEV searcher activity can lead to higher gas prices and network congestion as they compete to insert their transactions into blocks to capture the resulting value.
On a fundamental level, if the value from reordering transactions in a previous block is greater than the rewards and fees of the next block, MEV could make it economically rational for a block producer to commit to blockchain reorganization. This would then 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 within the space.