Ask CryptoVantage: What is Miner Extracted Value (MEV)?

Front Running

The closest analogy to illustrate how MEV works is front running. This is an illegal practice in traditional financial markets wherein a privileged party has access to knowledge about a trade. However, in DeFi and cryptocurrency, front running is commonplace because there is really no way to regulate it.

Before a trade is finalized within a block, the entity with the knowledge of the trade (a miner) executes a trade ahead of the trade they are aware of. Since they got their trade in first, they have the advantage. Let’s illustrate this with a concrete example.

• Trader Joe wants to buy $1,000,000 worth of ETH using USDT on UniSwap. Such a trade might increase the price of ETH by 1%
• Trade Joe initiates his trade on UniSwap and waits for it to be confirmed
• Miner Susan detects the trade and notices that she can buy ETH with USDT ahead of Trader Joe
• Miner Susan places a smaller but still significant trade for $100,000 worth of ETH knowing that Trader Joe will buy ETH right after her
• Miner Susan arranges the transactions in the block so her transaction is processed before Trader Joe’s
• The block is produced and included in the blockchain, making the transactions within it permanent
• Miner Susan then immediately sells her ETH she just acquired in the previous block after the price increased by 1% from Trader Joe’s trade
• Miner Susan made $1,000 (1% of $100k) by “front running” Trader Joe

Front Running in Traditional Finance

The practice of front running is considered to be unethical and is illegal in traditional financial markets. The reason is that the entity doing the front running is manipulating the market by leveraging private information that isn’t available to the public.

This entity has an outsized unfair advantage in the market. Banks, hedge funds, and portfolio managers have all been caught front running as it is a surefire way of making a profit if it can be done.

MEV and Systemic Risk

With an understanding of miner extracted value, we can now ask some questions and make some statements about the systemic risk it poses to the systems it takes place on. For starters, it seems like MEV is a byproduct of transactions being included in blocks, and the blocks being produced by entities that can be ethically compromised.

Since miners are anonymous and geographically distributed, regulating their behavior is infeasible. This raises the question, can a decentralized exchange exist on a decentralized blockchain without some amount of MEV taking place? I don’t think it can. MEV may be an unfortunate side effect of decentralizing our financial systems to the point where they are impossible to regulate.

Upon further analysis, we discover that the entities with the greatest ability to produce a block simultaneously have the largest competitive advantage on 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 stake networks.

From my point of view, this looks like systemic risk in blockchain driven decentralized exchanges. Value in the system is able to be extracted unbeknownst to the entity or entities it is being extracted from. Adding insult to injury, whoever is having value extracted from them is unaware of this happening, nor would they have any recourse for recouping funds if they were aware. Just because they’re unaware, doesn’t mean MEV is not wrong, damaging, or unethical.

Is There MEV on Bitcoin?

There is no such thing as miner extracted value on bitcoin, because there are no trades that take place on bitcoin. The only thing that the bitcoin network facilitates are transfers. From this perspective, it is simply a settlement layer for a single coin, BTC. The bitcoin business and development communities have opted to scale bitcoin by building peripheral systems for more complex use cases such as decentralized trading. It is their opinion that the 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 bitcoin in centralized, but regulated ways. The ethics of not allowing front running then falls onto the companies running the exchanges. Enforcement is possible in this case because companies and their operators can be held legally accountable for unethical or illegal financial practices such as front running.

The Tradeoffs of Blockchain Based Finance

If we want a decentralized financial system, then we will likely have to deal with a certain level of unethical behavior such as MEV. Remember, blockchains are run by miners, and anyone can be a miner. In the end, individuals, companies, and even governments all over the world have opted to become miners. What may be illegal in one place, may not be illegal and thus enforceable in another.

There are clear benefits to using blockchain based financial systems; low-fees, transaction times, and financial independence to name a few. However, these benefits do not come without their tradeoffs. They come with the fact that decentralized systems are decentralized, and thus are difficult, if not impossible, to regulate. We will have to learn how to live with a certain level of unethical behavior if we also wish to see a financial world dominated by blockchains.